How to Trade

High frequency finance, with the analysis of tick-by-tick market data, offers new insights in how to trade. Before you continue reading, I want to caution you that over 80% of the traders in any one-year lose money. Of the 20% who ended with a profit, many were just lucky and are likely to lose money in the following year. Does this mean that it is impossible to make money in financial markets? No, definitely not – it is feasible to earn money on a consistent basis, but it is difficult.

The reason why you can make money is simple: during the course of one year, the price risk is a lot smaller than the profit opportunity. The price change from say the 1st of January to the 31st of December for a particular exchange rate is 10, 20 or rarely 30 percent. If you sum up all price movements larger than 0.05% during the course of one year and deduct transaction costs, then you could, with perfect foresight, earn 1600% without leverage - that is more than 50 times the risk of 30 percent, so a big opportunity to make money does exist.

Trading is so difficult because 98% of the volume in liquid markets is speculative; only 2% is fundamentally driven. The 98%, the speculative volume, is the major force of the market determining the price trajectory – you need to understand the behaviour of the speculative traders to make money.
 

What is covered in this Booklet?

In this small booklet I discuss how traders need to restrain their natural urge to open large positions. There is an abundance of trading opportunities. So for any one trading idea, it is better to reserve a limited amount of capital and to have a contingency reserve in case that the trading idea was premature.

I also discuss apparently irrational market movements that turn fundamentals upside down. They occur when an initially small price spike triggers a whole cascade of price moves fuelled by a sequence of margin calls. When market participants have large unrealized losses, any small price spike can trigger margin calls; the position closeouts increase the imbalance of buyers and sellers and fuel a continuation of the price move, which may last for only a few minutes or hours, but can also take days, weeks or even months.

Finally, I will cover a number of different issues from turning a losing position into a profitable trade through active management of the position to implementing stop loss strategy and trade diversification.

This booklet does not include any technical or fundamental analysis. In general, the usefulness of these methods is exaggerated. You might be shocked to read that I do not have a lot of faith in their ability to be good predictors of financial markets. These approaches scratch the surface and can only spuriously explain the market movements – they seem to work precisely because the coastline of price movements is so long. The tools are helpful because they provide a frame of reference and are a means of making your trading decisions more consistent: When you get bruised by big losses or your ego gets ahead of itself, you should stick to your trading strategy when it prints money.

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