The Global Trader: Strategies for Profiting in Foreign Exchange, Futures, and Stocks

Overview

TRADE THE WORLD WITH CONFIDENCE

"Barbara Rockefeller brings the authority and perspective of a knowing insider to this well-written account of the risks and opportunities in trading highly leveraged markets like interbank currencies and futures."
-Nelson Freeburg, Editor, Formula Research, Inc.

Face it, the U.S. stock market has been analyzed to death. Long- and short-term investors are looking outside domestic markets to enhance portfolio performance and diversify the way they ...

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Overview

TRADE THE WORLD WITH CONFIDENCE

"Barbara Rockefeller brings the authority and perspective of a knowing insider to this well-written account of the risks and opportunities in trading highly leveraged markets like interbank currencies and futures."
-Nelson Freeburg, Editor, Formula Research, Inc.

Face it, the U.S. stock market has been analyzed to death. Long- and short-term investors are looking outside domestic markets to enhance portfolio performance and diversify the way they trade. This is why the concept of a global trader has become so prevalent. Whether you are looking to balance your portfolio, generate profits, or hedge risk, The Global Trader can help you make informed decisions about your global investments. Let Barbara Rockefeller unlock the opportunities and help you find the tools, guidance, and resources to make the most of trading in the less efficient yet potentially more profitable global markets of Europe, Asia, and beyond.

www.wileyfinance.com

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Product Details

  • ISBN-13: 9780471435853
  • Publisher: Wiley
  • Publication date: 12/3/2001
  • Series: Wiley Trading Series , #104
  • Edition number: 1
  • Pages: 272
  • Product dimensions: 6.26 (w) x 9.35 (h) x 0.96 (d)

Meet the Author

BARBARA ROCKEFELLER is the author of CNBC 24/7 Trading (Wiley) and is the founder of Rockefeller Treasury Services, an independent research firm specializing in foreign exchange forecasting and currency management. It publishes two daily reports on international economics and foreign exchange (www.rts-forex.com). A seasoned financial writer, Rockefeller is a columnist for worldlyinvestor.com and has written for many financial publications. She has also taught foreign exchange in many countries around the world. Previously, she was risk manager in the International Corporate Finance Division at Citibank. She holds a BA in economics from Reed College and an MA in international affairs from Columbia University.
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Table of Contents

Introduction.

Trading versus Investing.

Inefficiencies Galore.

Why Not Bonds?

Futures.

Some People Just Don't Get It.

Foreign Exchange.

Adventures in System Building.

The Hedge Fund Model for the Evolved Trader.

Index.

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Introduction

Introduction

Trading and investing are not games, but you should think and act as though they are. You would not bet on a losing poker hand, and you should not bet on a losing investment position, either. Every time you put down money, it should be with an expectation of a gain. This is called "positive expectancy" and involves calculation of the probability of gain. It also involves calculation of the probability of loss. Every famous trader talks about loss. Some traders go so far as to say that when they sit down at their desk every morning, they say aloud: "how much will I lose today?" This is neither an unhealthy obsession nor a morbid emphasis on the dark side of life; it's a clear-eyed interest in the internal battle of the psyche when it stares failure in the face.

Positive expectancy is not just some vague idea that every trade will be a winning one; it should be a statement of a specific dollar number. Psychiatrist Ari Kiev finds that naming dollar targets improves results enormously. It is not true that results depend on "the market"--how trended it is, or how volatile. Results depend on the trader. A trained trader--or a natural-born trader--walks a tightrope spun out of self-confidence, and self-confidence is stronger than steel. Tightrope walking requires perfect focus and concentration; it is not a part-time hobby that leaves room for doing six other things at the same time. Self-confidence comes partly from doing the work that precedes the trade.

"Doing the work" of trading consists of finding the combination of analytical techniques for which you have an affinity. These may be fundamental or technical, or rooted in sociohistorical insights--it doesn't matter. You cannot buy a winning technique in a book or a software program. Conditions will always be slightly different for you, and your implementation will always be slightly different from the next person's--because of you. No system is entirely rule based; some personal judgment is always needed. You will not be able to trade a system that embodies a holding period time frame or a win-loss ratio that you find unsympathetic. Discovering a trading methodology that is suited to your character and personality is a voyage of self-discovery.

The biggest obstacle to becoming a successful trader is your attitude toward losses. The value-investing school that is dominant in the United States today holds that losses don't count if you really have bought a value stock. "It will come back" is utter nonsense. You cannot know with certainty that you have a value stock, and there is no game in which losses do not count. Trading and investing are not games, and the theory of gambling and statistical logic is not arguable. The biggest con game in the world is the assertion, by stock brokers and mutual fund peddlers, that holding stocks for the long run will result in compound annual returns of 12 to 16 percent, as history has shown. There is no rate of return inherent in U.S. stocks--or in any other investment, except bonds.

Nobody knows where and when we started to accept a phony semantic distinction between "investing" and "trading." Old-time Wall Street legends like Bernard Baruch and Gerald Loeb would be appalled. They viewed buy-and-hold as the real gamble. You make actual money only when you sell. Moreover, you take no risk when you are out of the market. To say that you are investing your savings in the stock market and, at the same time, to say that trading in and out of the stock market would be too risky, is to accept an illogical proposition. This was blindingly obvious to commentators as early as 1870, when a large number of books about Wall Street started to appear. Many have been republished by the Fraser Publishing Company of Vermont, by Ed Dobson at Traders Press, and, in the 1990s, by big publishing houses such as McGraw-Hill and John Wiley & Sons. These wonderful books have titles like The Theory of Stock Speculation (1900), Studies in Tape Reading (1910), Studies in Stock Speculation (1924), and The Art of Speculation (1930). If you see these books at a garage sale, don't hesitate. They contain exactly the same advice and perspective as any trading book today, without the pious and false distinction between "investment" and "speculation." Trading stocks and commodities has inherent risks, and you might as well face them head-on, acknowledge that all market trading is speculation, and learn as many of the tricks of the trade as you possibly can.

Pointing this out is probably like preaching to the choir. After all, you are holding a book with the word "trader" in the title. But, like most people who have been brainwashed by the prevalent equity culture today, you are probably quite tentative and not fully committed to the idea that you will lose money on over half of your trades and it is the minority of trades that will make your stake grow--or it will be the one based on a lightning flash of insight, on which you bet big.

As Alexander Fleming found when he accidentally discovered penicillin, our brains achieve synthesis of a new idea after long, grinding analysis. You may have to trade for many years before you spot a trading opportunity so big that it is worthy of a big bet. Meanwhile, the best approach to trading profits is to make consistent small bets where the odds are in your favor but no single trade can be a catastrophe that knocks you out of the game. In this book, trading opportunities are named "inefficiencies." This is what professional traders are looking for, although they may not use that word. An inefficiency is any misperception by market participants of the true value of a security. It is the basis of Graham and Dodd's advice to buy stocks when they are temporarily at 60 to 70 percent of book value, and it is the basis of technical analysis trading, whereby you take a position when the price is temporarily off the trend. Academics mistakenly believe that markets are always efficient. They are not. They are inefficient more often than they are efficient. Efficiency is a process, not a state. This is why Value Line, which identifies undervalued situations and statistically projects the correction to true valuation, has been so successful for over 50 years.

We chose global markets because they are less efficient than equity markets in the United States. Let's face it, the U.S. stock market is thoroughly picked over and analyzed to death. In Europe and Japan--let alone emerging markets--the securities industry is less than 20 percent the size of the U.S. establishment, and that includes the number and quality of securities analysts. The citizens of foreign countries are not as involved in stock markets, either. Participation by individual Europeans is less than 20 percent (compared to 50 to 60 percent in the United States); and in Japan, participation is less than 10 percent. On the other hand, individuals in those countries are far more savvy about the foreign exchange market than Americans are, and foreign-currency-denominated accounts in both places are common. They are rare in the United States.

Americans are overinvested in the U.S. stock market. To diversify into foreign stocks is not necessarily the best answer, or the only answer. The stock markets in major countries are highly correlated with the U.S. market, or with one sector of the U.S. market. The Morgan Stanley Capital International index for Europe, Asia, and the Far East (EAFE), for example, was 50 percent correlated with the S&P 500 for the 30 years leading up to 1995, but 74 percent correlated with it in the five years from 1995 to 2000. The Taiwan Taipei index and the Korean KOSPI are highly correlated with the Philadelphia Stock Exchange Semiconductor Index (SOX). Other examples of correlation abound, but you won't find them neatly listed in a book or a financial periodical.

The diversification analysis performed by brokerage houses and Web-based services use long-dated correlations that are increasingly out of date, and many other untenable assumptions, such as the expected rate of return, also based on long-dated past returns. The result is that you have no idea what risk you are really taking. Portfolio theory is elegant, and impossible to refute. It's also impossible to implement without making a lot of assumptions and guesses. To diversify correctly, you would need to look at markets and securities as disconnected as possible from the S&P 500, the Dow, and Nasdaq, and evaluate their correlation--or the absence of correlation--on a one-by-one basis. Nobody is offering a "beta" today for each security in the world vis-à-vis the S&P 500, but this is not as hard as it sounds, especially since, as a trader (rather than an investor), you are no longer considering your holding period to be "forever." You can easily construct a correlation study in Excel or Lotus.

You can stay in stock markets, if you prefer, but you would be bypassing one of the great diversification opportunities of all time--the futures market. Leaders of the equity culture work very hard to keep you from noticing the futures market. They constantly issue warnings that the futures market is ultra-risky and nearly everybody who ventures there loses his shirt. But many securities in the futures market are less volatile than equities. What makes futures markets riskier is the use of leverage, or borrowed money. Most people cannot grasp the essence of leverage and do not apply sensible rules of trading, so horror stories abound. There is a vast difference in the mind-set of equity market participants and futures markets participants--and their brokers, analysts, software programs, and press. "Business" periodicals such as Forbes, Business Week, and Barron's focus exclusively on equities; when they write about futures trading, they are disapproving. This is partly because they view technical analysis, universally used in futures trading, as some kind of unproven voodoo that will inevitably lead the reader to ruin. And yet, unless you are going to "buy value stocks and hold forever," at least some rudimentary technical analysis is essential for trading success.

You will have to overcome the prejudice against futures trading that is widespread in the United States today. Futures trading is in fact a good place to practice trading any global security, whether it is a Chinese stock, German bond futures, or deep-discount Argentine sovereign debt. Futures trading forces you to consider the probable win-loss ratio very carefully, and that is the key to all trading success. The advanced academic work that is being done today on risk--measuring it, managing it, and systematically exploiting it--is being done in the futures markets. Technical analysis and its cousin, money management, are integral parts of futures trading precisely because they are the tools that help you calculate the probability of winning and the probability of losing. Technical analysis proponents sometimes claim too much for it; they say that it is like having inside information on what's going to happen next. You don't need to go that far to take advantage of a useful tool.

Don't think that you can bypass technical analysis and risk management if you chose to bypass futures trading. You still need an estimate of the probability of winning in any trade and an exit strategy when prices move against you. You probably do not speak and read Chinese, Hebrew, or Turkish--and you wouldn't necessarily be any the wiser about specific securities and markets if you did. Technical analysis is the one tool that transcends language. Fortunately, this means it also transcends BS and is thus very liberating.

Technical analysis cannot, however, predict a price shock. A price shock arises from a surprise event that was not on anyone's radar screen, except the few who are carefully imaginative. A price shock develops from a series of events and culminates in one big event, whereupon, with perfect hindsight, everyone recognizes what has been going on all along. This is why we read. We are seeking information to build two insights: first, what securities price development exaggerates true conditions, either overvaluation or undervaluation. Once we find an obvious case of mispricing, we can imagine that some shock or event must come along to reverse the perception. The best story to illustrate this process is Jim Melcher's realization that, after the Russian sovereign default in September 1998, at one point the entire Russian stock market was worth less than half the value of Yahoo! He bought near the bottom and booked a 160 percent gain in only a few months. No newspaper reporter had observed that the Russian market was so undervalued. If one had, he would have become a trader instead of a newspaper reporter. But news reports are the raw material for creating insights and, make no mistake, a creative process is involved. Much pompous bumf is written about the creative process, but let's just say that it is not entirely rational and logical.

The second insight we seek by reading is to guess what will influence institutional investors, who, collectively, are the real driving force in every market. Chat-room visitors mistakenly believe that what influences them is also what influences institutions. They err in falling in love with their stocks, forgetting that a stock is not the company. Institutional investors are far more hardheaded but are, at the same time, just as susceptible to herd instinct as anyone else. The phrase "herd instinct" is a semantically insulting way to describe group behavior. But professional institutional investors are required, by their own rules and their contract with their clients, to meet or beat benchmarks, which, by definition, are the grand sum of group behavior. An entirely contrarian institution may hit an occasional home run but is generally doomed to remain small. Individuals buy into professional management precisely because they want to meet or beat benchmarks. On the whole, professional managers fail to do even that, which raises the question again: what do we really seek when we trade securities markets? Is the goal to prevent the loss of capital (defensive) or to make money (active)? Anyone who made a first investment in the U.S. stock market in March 2000 failed to prevent the loss of capital one year later if he had bought into a standard index-tracking mutual fund. In what way is this defensive and protective of "savings"? What risk aversion means to the individual is very different from what risk aversion means to the institution. Risk aversion to the institution means avoiding anything that jeopardizes the ongoing existence of the institution. It does not mean maximizing your cash. Having said all that, we still need to be able to predict what institutions will do in the face of price shocks and watershed Events. There is no point in analyzing a situation correctly if the crowd does not also come to the same realization.

Economist John Moffatt, at Analytic Systems in New Hampshire, says that the price of stocks is determined by three factors: (1) 50 percent, market influences; (2) 25 percent, the macro-economic background, and (3) only 25 percent, the fundamentals of the company itself. This suggests that picking a rising-star company in a falling market is likely not to yield the gains you might expect, especially if the company's home-country economy is in a slump. Further, you may want to keep the bulk of your investments in the United States, if only to avoid foreign exchange risk. The top-down approach would be: first seek a rising market, then make sure the economy is rising, then seek specific securities. Meanwhile, keep an eye on any situations that are bottoming or are oversold, because we can guess that the next wave of market sentiment will likely be upward--possibly, to an excessive degree. Many if not most of these situations will be high risk in the conventional way of looking at things. Country or sovereign risk may be high. Disclosure and transparency may be awful. Liquidity may be low and price volatility high. The currency may be a problem, including convertibility (back into U.S. dollars). Nevertheless, these situations are where the high-probability gains are to be found.

The world is a big place, and trading is a zero-sum game--your gain is someone else's loss. You need a well-stocked toolkit to venture outside of a "strategy" of merely buying U.S. mutual funds. Don't be a cheapskate. Get the tools you need. Nicholas Darvas describes how he made $2 million from remote places in the world with no tools except stale copies of The Wall Street Journal, a hotel telex machine, and his theory of how prices move (Nicholas Darvas, How I Made $2,000,000 in the Stock Market, Lyle Stuart, 1971). You could do it, too. But the world is faster-moving than in Darvas's day (the 1950s), and the tools are cheap. If you are starting literally from scratch, you will need to get subscriptions to the major world newspapers and business periodicals, a data service, several newsletters, and a technical analysis software package, not to mention a PC to run the software and access the Internet. You will also need 10 to 20 books. The total cost of all this is $2,500 to $5,000, depending on how fancy a PC you get. Ongoing subscription and data costs will be about $100 to $300/ month, or $1,200 to $3,600 per year. This may seem like a big investment, but consider what you pay in fees to a mutual fund--1 to 4 percent--and the return you expect to get on the outlay by doing the work yourself. You should be able to recapture the capital investment in the first month or two, and you should target your return to do precisely that (following Kiev's advice).

Almost every writer on trading has at least one valuable point to make that you can use in your own trading. You can buy books and file magazine articles for the rest of your life. At some point, you have to choose which market, which specific security, and which specific technique you will use. The secret of trading, which a lot of people do not want to admit, is that everything works. Cycle theories, with or without astrological overtones, work. Pattern recognition, once you train yourself to see patterns (whether of the head-and-shoulders variety, or Japanese candlesticks), works. Statistical techniques, whether you use channels or arithmetic formulations such as moving averages and momentum, work. Neural networks, which find organization within apparent chaos, work. Today, we have computers and software to help implement all these techniques, and the techniques work.

No technique works all the time, and no technique works on every security, so you have to find what works on your security or pick a technique and find what securities it works on. In the end, the only really difficult question you have to address is the time frame of your trading. If you can see big-picture trends and therefore choose a long time frame, there is a set of long-term indicators that will work on your securities. Be aware that long-term trading, in which you hold a position for months and even years, is where big one-time gains are to be made--but also where big one-time losses may occur, too.

If you pick a shorter time frame--for example, today's popular "swing trading" of three, five, and eight days or weeks--you will use a different set of techniques and a different mind-set. You will need to be more opportunistic--that is, less emotionally committed to the trade--because, at this level, the market is throwing off a lot of "noise" (random moves). You therefore have to have a personality that is more accepting of high risk and of frequent losses.

Most individuals think that they need: first, a trading system; next, a money management system, and last, a way to train themselves to operate the trading and money management system with discipline and focus. This sequence is backward. The first thing you need to do is: take an inventory of yourself and find out what securities are suited to you. If you do not have the patience and the time to follow economic and market conditions in China, you have no business trading China Telecom, even if you are a world-class expert on the telecom industry. If you have the time and energy to follow conditions in China, it doesn't matter what trading system you adopt to trade China Telecom. Any number of equally valid trading systems will work just fine to give you buy/ sell signals. Then, of course, you need to follow the signals scrupulously. Buying is easy, selling is hard. But as the great traders of history point out, you make money only when you sell.

It's important to acknowledge that the rules of the game are not what the brokerage and mutual fund industry would have you believe. A key theme of this book is that trading isn't what you think it is. Active trading is factually and logically far more defensible than index-tracking. Index benchmarks are meaningless because they are rigged to include the best and the brightest in a continual process of discarding losers. A company is not its stock, anyway. Once you realize that the "value" touchstones peddled by the securities industry are dross, you might as well go global, where the opportunities are. Because it is very difficult to determine intrinsic value in foreign securities and to become fully familiar with market conditions in foreign countries, you are liberated to trade foreign securities (or derivatives) on the price action of the securities themselves. It is a deductive and rational process fully divorced from false-belief systems.

This is a harsh message. If you want to be a global trader, you have to devote a great deal of time and energy to the effort. You have to hold two ideas in your mind simultaneously: (1) the big-picture opportunity, and (2) the price vagaries of your specific securities. If, for example, the Chinese stock market is the place to be and you have selected a Chinese telecom stock, but suddenly the entire telecom sector worldwide starts tanking, including your stock, you need an exit rule that will keep your head clear. Then you need to apply the rule and actually exit, even though you have persuaded yourself that the "story" is a good one and "it will come back." Things change. It may not come back, even if it "should." In the meanwhile, some other security is worthy of your attention, and if you can't find such an opportunity right away, there is only one place for your cash--short-term U.S. Government paper. This is why global professionals rank markets according to attractiveness, and retreat to the zero-risk security when none of them measures up to the sure return on cash. Notice that the fall-back position is not a U.S. securities-based mutual fund.

Above all, you have to be realistic about the gains that can be made in your chosen securities, and the losses that will inevitably accompany them. It is usually unrealistic to expect a security that has already risen 150 percent to rise another 150 percent. It is also unrealistic to expect to recover losses at a pace of 100 percent, which is what is needed if you lose 50 percent of your stake--unless you are specializing in a security that routinely and predictably changes by 100 percent and you are sure that you are on the right side of it. Target each gain--and each loss, too. That's what professionals do that makes them different from the average trader.

A global trader is different from an average trader because he sees a bigger universe of opportunities--one that includes foreign bonds, emerging markets, futures, and all manner of newly developed instruments and securities. A global trader targets the one with the highest positive expectancy--and nails it down by not holding it too long and always entering a stop-loss. If the highest positive expectancy is in U.S. equities, so be it--but we should not automatically assume that U.S. equities are the "safe way to save." If you want to protect savings, buy bonds. If you want to trade, start looking for positive expectancies.

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