1. Market prices are determined by how do events transpire relative to what’s discounted. This is such a critical point. It explains why AMZN can trade for 100 times earnings and AAPL for 10 even though AAPL has made more money this quarter than AMZN made it its whole corporate existence. In FX it explains why prices rise on bad news and fall on good news. The key question to always ask isn’t what the number will be, but what is really expected. Furthermore, the greater the price rise ahead of the move the greater the beat must be in order for prices to ramp even higher. Its always this dynamic interaction between price and expectation that creates direction in the market. That’s why markets are not a reflection of reality and that’s why they can frustrate so many traders.
2. Understand Risk Parity. What’s more dangerous? Own a stock portfolio for cash or borrow up to 100% against a bond portfolio. Surprisingly enough the second option is actually less volatile. In investing one thing is not like the other. Assets have very different profiles and allocating 50% to one and 50% to another could mean that you are still assuming as much 80% of the overall risk. In FX this means that you can not size all your trades the same way. 100,000 units of GBPJPY is not the same risk as 100,000 units of AUD/USD. Know the average true range of the currency pair you wish to trade and normalize position size to your individual risk tolerance.
3. Know when to walk away. Mr. Dalio agrees with me the markets are a zero-sum game. ( See last week’s column). He uses a poker analogy to basically say that if you sit down at the table and you don’t know who the sucker is -- then the sucker is you. Risk avoidance therefore is the paramount goal of any successful speculator. For the retail forex trader the two biggest sucker moves are to trade on ultra-short term time frames in combination with extreme leverage. Eliminating those two behaviors will not guarantee success but it will certainly reduce your chance of failure.
What’s amazing about the Dalio interview is just how common sensical his advice is. For forex traders the world over his words should be received wisdom as we battle the markets every day.