The Golden Rule of Risk Management

Today's Guest Blogger is frequent TV contributor, Bob Iaccino from TraderOutlook.com. Iaccino will try to take a stab at teaching us about the importance of risk management in the Forex markets.You can also see Bob's recently released video series, charting his trading methods and successes. Make sure you comment below with any questions you have for Bob.

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Position traders are suffering a little bit, both short and long term in the Forex market right now. Even scalpers are feeling the sort of chop they haven’t felt recently because of the lack of “trend/congestion, trend/congestion” that has been the consistent general nature of the Forex markets. When the economy is in a particular phase such as recession, growth, or even depression, we’ll see the Forex markets trending. However, the direction of the trend doesn’t ultimately matter. They’ll trend for a period of time, and then they’ll pause and move sideways.

Right now the sideways motion is filled with mini-trends. Let me give you an example. When looking at a 4 hour chart, you’ll see one, maybe two periods of consolidation followed by a massive emotional candle. Then you’ll see two or three periods of consolidation and a massive emotional candle to negate the previous emotional candle’s move. Normally, Forex markets have a steady pace of “trend then congest..trend then congest.” Right now it’s more a cycle of “trend, congest, trend, congest.” There’s a departure from the signature trending cycle.

The reason behind this is fundamental in nature, because the market is in a switch between recession and growth and its undecided if that switch is actually going to take place. What do I mean by that? Growth cycles last somewhere in the range of 5 years on average dating back to the Great Depression. More recently, we’ve seen spiked up growth during the Clinton and George W. Bush years. Those cycles of growth are fairly long compared to historical levels. Recessions generally last somewhere around 2 years, but more generally in the range of 14 months on average. During those periods, the 14 month recessions or 5 years of growth, the Forex markets will trend. By virtue of being the largest traded market in the world and the largest transactional entity, meaning that money changes hands more than with interest rates or commodities, the greatest need for hedging is in Forex.

Large hedgers, ones that do billions and billions in transactions at a time, hedge for general economic conditions. An example would be a large insurance company. They’ve got sizeable holdings of gilts* (Risk-free bonds issued by the British government, equivalent of U.S. Treasury securities) and the interest rates on gilts are heading lower. They will hedge their currency exposure, based on a large exposure to the guilt, for a period of time. Say the economy then switches. Growth can cause higher inflation, causing higher interest rates. If higher interest rates occur, those large holders of gilts, in the multi billions of dollars worth, now need to hedge for higher interest rates as opposed to lower. So they will then switch their hedges from one side to the other. The timing of that is the current question Are we actually switching to growth?

If not, they would need to switch their hedges back. The reason we’re seeing these large moves, is that hedgers will come in on large news and reverse the hedge the other way. They’re not sensitive about the moment to moment movement. They may reverse the hedge half a dozen times. If they have the hedge on the right way and the economy is heading in the proper direction, that hedge will stay on for a long time, sometimes years. They’re not in and out traders. This is what’s causing the strange trading in the market right now that’s affecting position traders and scalpers alike. It’s not a time to question your strategy. It is a time to pull back risk in your trading and sit and wait for the economy to stabilize in one direction or the other. What direction is unimportant. Refer to our motto, Never increase risk, always reduce it when in doubt and this is one of those times.

Bob Iaccino
Thanks again to Adam for the ability to write for you today, and if you're able, please check out my series of videos showing how I work here.

5 thoughts on “The Golden Rule of Risk Management

  1. Bob does NOT state if there are trading cycles within the LONG and SHORT terms, yet there are trading opportunites at all times within the cycles. When consolidating you stay out, other than that it's time to trade - day OR scalping. Right ??

    Bill N.

  2. What I believe is being inferred here is that there is too much risk on the table. You ought to cut back. The interpretation I think you are having (and I would too based on this writing) is that the economy could turn up even more (or actually get pumped up by media, funds, and retail) with the hedgers not unwinding their bets (thus contributing to an overall up trend). The first portion of the 2nd paragraph indicates that the increased volatility (21 day trend and internal daily trend) is due to hedgers winding and unwinding positions quickly because there is "uncertainty" in their view.

    What the author is asking you to do (in no certain clear terms) is to wait out this period of volatility and high risk by gradually reducing your risk here at this point in time (Nov/Dec 2009) to see where the true trend is. If you miss out on a few points to the up or downside, so be it. Just wait for confirmation of where this is market is going (up or down) due to valuation and risk picture. Hedgers that "will stay on for a long time..." indicates that you'll have years of up time to gain on. Now the trick is whether you'll be savvy enough to catch a "trend" one way or another. On the downside, this could be a break below the 100/200 day moving average. On the upside, this could be anything above 1180-1200 on the S&P and 11500 on the DJIA (based on up to 10% above the recent high, then wait for a pullback to get back in from there).

    If you stay in the market now, you may catch the ride up, but you could also get caught in a fast draft downward too (need we be reminded of what has happened in the UAE markets in the last two days?). Be ready at this point in the market valuation to lop off up to 2-5% or market cap in one day's time due to some "unknown bad news" hiding or waiting to be revealed.

  3. I agree with the comments made by the previous poster. The final paragraph lacks a coherent and transparent thought process; Actually, at times, the logic seems somewhat circular and outright confusing. However the overall piece presented some interesting thought provoking insights and observations.

  4. Bob, it would be difficult for scalpers to wait untill economy moves in one direction or another. This process can easily take weeks or months, before clear direction emerges. While long term trades can conceivably stay on the sidelines that long, others should adjust strategies, or limit exposure by reducing position size. Besides, trading opportunities are present, it just depends on what exactly one is looking for. However, risk aversion is always important, no matter the trading environment.

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