Outsourcing the Decisions with Scott Barlow

The following is an excerpt from Every-day Traders and even though this interview took place back in 2001, the lessons still strongly resonate today. Indeed, this interview still makes an appearance on many FX blogs and forums around the world. This is a long article, but well worth the read. Grab a cup of coffee (or a beer) and enjoy…

At the time of the interview, Scott Barlow was a foreign exchange (FX) trader based in Sydney. He has extensive industry experience and, in light of FX trading becoming more popular in recent years, was a prime candidate for this book.

Many may struggle with Scott’s perspective, yet the underlying philosophy of profitable trading makes complete sense. In a nutshell, Scott’s trading style is ‘cut the losses and let the profits run’ and while this is something that we hear time and again and put down to one of those old yarns running around, Scott takes this to a level that many may not comprehend or even desire. It’s natural for us to believe that we are in control—or at least for us to desire to be in control—of our destiny, and in trading that means being in control of the decision-making process of when and what we buy. This is the last thing on Scott’s mind. In fact the only thing on Scott’s mind is risk control, which is ironic, because most new traders do it the other way around. For them, first comes entries and exits, then some risk control for good measure.

When I first approached Scott for this interview he was wary for two reasons. His first concern was that I would direct the questions according to my own beliefs and his second was that I wouldn’t agree with his philosophy of trading. I convinced Scott that I was simply the conduit for questions and answers and my intent was to relay information from those with the knowledge to those who wanted to learn. This book was not a personal endeavour to get my own philosophies across to the masses. After this he agreed to proceed but warned me his style of trading would astonish me and go against everything I believed in. He wasn’t wrong…

What’s your opinion of mainstream analysis?
People need to recognise that there are some serious flaws in both technical analysis and fundamental analysis and the only thing that will save them is risk management.

What flaws do you see in fundamental analysis?
There are thousands of fundamental factors influencing markets these days. They happen across the world every second of the day. The first thing to recognise is, as humans, it is impossible to absorb all these factors at any given time; secondly, it’s impossible to have access to them all at once; thirdly, because we’re human, we have a tendency to try and be rational. That is, we try to interpret fundamental events rationally and markets don’t always interpret a fundamental event rationally. An example would be an economic data release the market anticipates and ‘prices in’ prior to the release. An interest rate hike may rationally suggest prices will increase, but if upon release the hike is less than or equal to that which the market anticipated, prices may decline upon the announcement as traders liquidate their positions, satisfied they have milked the trade for all it is worth. So those three factors mean any attempt to devise a strategy that is a response to an event is possibly flawed right from the start.

I also have a problem with the concept of using financial markets as a vehicle to vindicate one’s theories or opinions. Admittedly, the world is awash with financial news and opinions and we are programmed to interpret these and to make financial and investment decisions, but all this news and opinion is not necessary when trading and it shouldn’t be applied —it’s just too risky and can lead to frustration.

Do you know any successful traders who use pure fundamentals?
Not personally, but perhaps well known to most people is George Soros. He may not have been a pure fundamental trader but from what little I know his approach has always been pretty macro and leans heavily toward the interpretation of fundamental factors. He’s had some spectacular losses as well as some spectacular successes but I don’t think he reflects the average trader on the street. Because he’s famous, I guess people hold him up as a role model, or it assists in the perception that he is the definition of what a trader does and thus what they should do, but that’s not always right. We cannot know his circumstances or the structures he has built around himself — and the funds he has access to require an approach that makes a comparison of his experience unreasonable when matched against a private trader.

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I might add that Soros may be a good example of cream rising to the top of the milk. People should realise that for every success there may be thousands who have ‘died’ along the way taking the same approach. It’s important in any evaluation of what constitutes a success to know the size of the graveyard behind the survivor, if you know what I mean.

So do you feel the normal retail trader, whether it be in equities, futures or whatever—and especially equities —would look towards their broker’s research and act on that?
I don’t believe many retail traders are in the trading game on that slow, long-term basis of taking a multi-year view of the markets using macro fundamentals as Mr Soros appeared to employ. On a retail level, you’re probably not ‘trading’ so much as ‘investing’ if your strategy requires you to hold onto positions for several months or years.

Are you saying that if someone considered himself or herself a profitable fundamental trader, they’re perhaps making their money using another technique
that they may not consciously even be aware of?Maybe they’re aware of the fundamentals but not aware of what’s actually making the money?
That’s exactly right. I think humans have a tendency to want to explain or rationalise how they arrived at some sort of outcome. Some people could be just described as lucky fools. Someone who happened to be in the right place at the right time for long enough and by attrition ended up on top. I think in the recent technology boom particularly we saw a lot of lucky fools—people who were telling all their friends they were trading but really all they were doing was buying stocks which, due to the momentum of the market, were just making spectacular gains. I think a lot of those people now are in a net loss position. A lot of people mistook luck for skill, and perhaps they still do.

In the peak of that boom, brokers and analysts tried to justify certain fundamentals to continue to drive the prices higher.
It’s easy for people to rely on that sort of information or just repeat it back to others but there was very little skill involved for a lot of people during that time.

You mentioned technical analysis is flawed. Can you expand on that?
I guess I’d better preface it first by saying that I use technical analysis but I don’t undertake the actual analysis myself. I subscribe to it because I’d prefer other people to waste their time on it rather than me. All the same, I use that technical analysis and put it into the risk model I’ve developed.

Let’s firstly define technical analysis the Scott Barlow way. There are various ways to look at it: there’s the public perception, which includes charts and lines and indicators; then there’s the statistical measure of it, which is usually the way systematic traders use it. Which do you subscribe to?
When I’m being disrespectful of technical analysis I’m referring to people pulling a chart up on their screen or on a piece of paper and drawing lines of support and resistance, adding indicators, moving averages and so on, and then pretending they can determine a direction that the market will take.

Probabilities and statistical analysis are things I’m much more comfortable with and have a much healthier respect for. Technical analysis is a necessary evil for me because it provides a foundation from which to derive a strategy that is consistent and consistency is extremely important. I don’t believe technical analysis should be used as a predictive tool but this is how many, many people use it and, unfortunately, how much of the literature
on bookshelves portrays it. I don’t believe anyone can predict the future with any degree of certainty and thus I don’t kid myself when I’m staring at a chart that this notion is going to change. Technical analysis becomes useful as a tool when it is used to assess, monitor and measure risks and probabilities that will assist you to return an income from trading. That said, I know one way to skin a cat—my way—and I accept there’s probably thousands of ways to trade.

Technical analysis books sell like wildfire. Why do you think that is?
I believe they are constructed to appeal to some very basic assumptions we hold about the markets and many of these assumptions about what it takes to trade financial markets profitably are just plain wrong. When a person picks up a book to determine if it is of interest to them, if their assumptions are not validated in the few seconds it takes to read the back cover, the author/publisher is not going to secure a sale.

Humans seem programmed to look for and recognise patterns where possibly none exist and on top of that I don’t think our human condition allows us to accept probabilities too readily. I think many trading books and software products play to these flaws.

From a very young age we’re programmed to work hard, try hard and look at life in a rational way, and many people through no fault of their own take this to the financial markets. Most people’s trading decisions will start with divining the information contained within a chart. Setting aside issues of reliability (of the information etcetera) and the vagaries of how one interprets the data, there have been enough studies or tests conducted where random numbers are graphed and the result looks remarkably like a bar chart we might see every day in the market. We humans then pretend there’s some recognisable pattern in the chart somewhere, one which we could use to make a trading decision. We seem predisposed to find patterns or answers where possibly none exist.

If people want to learn more about what it takes to trade, they should perhaps put down the books on technical analysis or the secret of this or the ten tips to that and instead pick up a couple of books on behavioural finance. They’ll learn about judgemental heuristics and the factors that are at play when we attempt to arrive at decisions. Recognising and understanding the biases that affect decision-making is key to my healthy disrespect for how many books on trading the market are pitched at consumers. As trading for many people is steeped in analysis, these biases creep into trading strategies that people
devise—particularly when backtesting a trading system—and new traders must recognise and deal with them if they ever hope to be successful traders.

For example, let’s take the bias that is described as the ‘illusion of control’. Even drawing simple lines on a chart offers an illusion of control. It’s the same as playing the lottery: if you choose the numbers yourself, somehow you feel you’re in control, you feel that in some way the odds are re-weighted in your favour. Despite the odds of millions to one against winning the Lotto, people are still happy to fork out money for that chance as long as they get to choose the numbers. Technicians are doing the same thing by drawing the line on the chart, by identifying the support or resistance level and then ‘picking the
numbers’ where they want to buy and sell—they’re succumbing to an illusion that they are in control and that the odds are now weighted in their favour.

Another way of explaining a bias is this. Have you ever seen the optical illusion where two lines of equal length are presented and one has arrows pointing in at the end of the line and the other has arrows pointing out? One of the lines looks shorter than the other and the illusion is fascinating. The thing is—even when we know that both lines are of equal length, our mind continues to see a shorter line—that’s what makes it fascinating. The pattern or illusion is impressive and our mind has an extremely hard time accepting otherwise. Now translate this bias to the interpretation of a chart of a financial market. No
wonder many charts seem incredibly impressive, allowing us to imagine all kinds of windfalls and opportunities if we were to become involved in trading.

Having faith in the strategy we’re putting together and having the confidence to execute it in real time are big issues for traders. When someone works on devising a trading strategy, they are working at constructing something. Yet we know from experience that to test the true strength of anything, we’ve got to try to tear it down—we’ve got to find fault in it if we are to have faith in it. This goes against the grain of trying to build something and unfortunately many traders devise and use methodologies that haven’t truly been put to the test in an adequate way. The real tragedy is that eventually the market will find their weakness and often at great expense.

Traders need to be able to change their mind; they can’t fall in love with their trading positions and that goes against the way we’re wired as humans. The ability to stand your ground or stand by your convictions is an esteemed trait in the human race, but it can be a disastrous quality for a trader. I mention this because when someone attempts their own analysis they are not only open to biases of interpretation and illusion as I mentioned earlier but they are more inclined to place a higher value on their interpretation than otherwise might be prudent.

This is principally why I don’t do my own analysis. I don’t want to allow any hard work I might be putting into my study of the market to hijack my emotions and abilities. I’d rather hand over the analytical side and just place a buy and sell order, after acceptance by the risk model. Yes, someone else is predisposed to these biases in determining the strategy before it is sent to me (as a subscriber), but I like removing the association anyway and I let my risk model take care of the rest. Some might argue that there’s no difference and I guess my other answer would be one of motivation—if I was to pore
over charts all day I might lose interest. Life gets in the way of many things we do and minimising the commitment that is required to apply myself to trading in a consistent and businesslike manner is an important part of my success. Outsourcing a portion of the work required makes sense to me.

You mentioned that you don’t use fundamental analysis, you don’t use standard technical analysis techniques but you did briefly mention that there are other more statistical methods that are used. Can you expand?
The probabilities I mentioned are as simple as (but not limited to) knowing how often I’m going to lose. Good foreign exchange trading is all about losing. If you can learn to lose well you’ll do well trading the FX market. I know I’m going to lose on 75 per cent of the trades I place. I know that the 25 per cent of trades that I expect to win on need to offset more than the accumulated total of the 75 per cent that I’m losing on. That’s a very simple thing for me to work with.

The human condition encourages us to try hard, to get better at something, to get more right than wrong in life as well as in our pursuits. I see or hear people working hard at perfecting their trading systems—they’re optimising, they’re backtesting, they’re trying to get better than a 50, 60 or 70 per cent win rate. Only once they get better odds do they feel confident enough to put these things into practice. But often the paths they’re going down to achieve these results in their testing phase are flawed. They’re flawed because the only way to achieve these results is to let the biases I mentioned earlier creep into their work. Even if I manage to do better than 25 or 30 per cent, it’s still a great base to start from. I’ll take a 35 or 40 per cent win rate as icing on the cake in any given year, but I’m certainly not expecting it. The risk model I employ allows me to go down to about a 12 or 15 per cent win rate to break-even.

Obviously getting it right such a small percentage of the time is extremely difficult to deal with. How do you get through it?
Mentally it’s a difficult thing to deal with, there’s no doubt about that, but the risk model gives me great faith. There are times where I’ve experienced 25 non-profitable trades in a row and still I appreciate there is possibly worse to come in my trading career. The whole idea of having an approach to risk management that is robust is to be able to wear those losing periods because they’ll happen, and in my experience they’ll happen at least twice a year.

Failing to get past a significant drawdown period is where a lot of traders fall over. They can’t stomach 20-plus losers in a row or they weren’t expecting it to happen to them or, more likely, their account can’t handle it. Certainly from my standpoint, I expect it’s going to happen and that the next one is probably going to be worse than the last one I had. So the risk model has to be very conservative and it has to allow me to get through that. In the long run the 25/75 per cent win/loss ratio exerts itself again.

When you say you expect the worst drawdown, how do you define that? Is that in dollar terms, in consecutive losing trades, timing? What is that exactly?
The size of the decline in your equity from one equity high to the next. It can be expressed in a variety of ways.

Is that 5 per cent, 15 per cent, 50 per cent?
Professional traders are aware of drawdowns and keeping them to a low percentage is appropriate. You have to look at the market you’re trading and your own approach and weigh up what is an acceptable drawdown in that market or compared to your peers. It’s hard to talk dollar terms. I really don’t look at the dollars, as strange as that might sound, but I do look at the percentages. It’s important to consider because you could start anywhere along your trading cycle and that could be right at the start of a 25-losing trade drawdown.

With a system that gets it right only 25 to 30 per cent of the time, the probability of having a so-called ‘start drawdown’ is remarkably high. Again, how would you expect a retail trader to deal with that, knowing very well that as soon as they start trading they’re going to start losing money with a very high probability?
I think a lot of people experience that anyway because they’ve got models or methodologies that are flawed to begin with. But even if you have a brilliant model, losses are part and parcel of the trading game. The focus should not be on avoiding losses; the focus should be on managing them. It’s extremely important to accept this.

I guess the most difficult part of your trading would be again the losing streaks and dealing with them. How do you separate yourself from that? What do you actually do? What goes through your mind?
Firstly, because I expect to lose, the size of the positions that I put on, relative to the leverage that I’m allowed, are quite small. This aspect is tied to the preservation of capital, which is my unbreakable and number one rule—it must be adhered to. There are three stages to each of my trades. The first is the identification of a low risk opportunity. That sounds subjective and to a degree it is, but what is important is that I don’t get into a trade if it requires a monstrous stop-loss to manage it. Because I subscribe to analysis I have to be sure the supplier fits this bill. The second stage—assuming a trade becomes ‘in the money’ (but is still short of my target)—I look for an opportunity to raise the stoploss to the level I entered the trade. With the stop-loss now at break-even, the position essentially becomes risk-free. The risk-free trade is something we should probably all aspire to. I’d love every trade to be risk-free but I have to work on it.

Once I’ve got my risk-free position, all I have left to do is to manage the exit. Whilst I use technical analysis, my proprietary risk model and a low-risk opportunity to get into the trade, I never use technical analysis to exit a position. I use only common sense to get out of a trade.

I’m aware that my 25 per cent of winners need to outweigh the accumulated total loss of my losers. If I’m losing on average 33 points per trade, for example, I need to make at least three times that just to break even. I think my win/loss ratio at the moment stands at something approximating 1:4.18, so as a guide I know I need to look for about 130+ points per profitable trade. I simply cannot and will not take a profit for less than this. I’m aware many traders find this strange but the presumption they rely upon is one of opinion. They say, ‘But what if you think the market is going to go against you and you lose what profit you’ve already got? Isn’t it important to book the profit no matter how small?’. The answer is absolutely no. This type of question tells me the person asking it believes that their opinion counts for something when it does not. In my mind, beginner traders aren’t willing to take losses—they hang on to trades in the hope they will ‘turn around’. Intermediate traders are past this, but they take too many small profits and both eventually get taken to the cleaners. Graduated traders on the other hand accept their losses and they learn to let their profits run.

Occasionally I’ll book a 300 or 600 point profit but most of the time I’m booking my 120 to 150 points. To book the larger profit, I have to be mindful on every trade of its potential. While I know what my initial target needs to be, I also keep a weather eye on what’s happening in the market and occasionally I’ll look to let the trade run well past the target. This is an important approach because currencies are famous for trending and I try to be aware that the trade I’m on could be the start of a big move. In foreign exchange, good-sized moves occur perhaps once a month, but it’s unrealistic to think you can catch
them all. Getting on the back of a really good run once a quarter is more realistic and I try to aim for this. Taking that extra bit when it presents itself is what will help you achieve outperformance or it just might save you from a negative year or a sub-objective year.

You’re saying that one great trade can make all the difference?
When I had 24 non-profitable trades in a row recently it only took one trade to erase them all.

Again this comes back to a very basic concept: cut your losses, let your profits run.
Yes, absolutely. It sounds like a typical market cliché but never a truer word has been spoken. I’m happier taking lots of little losses, knowing that the market’s working for me, that my profit is on its way and, when it comes, will be substantial.

So you knew losses were likely to happen and therefore accepted them and continued. Would you agree most retail traders are not prepared for losses and as soon as they experience them they switch off their system and go in some other direction?
All I’ll say on that is, if you’ve got some sort of methodology that you’re employing and you balance that with a good approach to risk management, no matter how flawed your entry rule is it should allow you to withstand many losses without too much damage to your account. Entry techniques aren’t vital. The important stuff comes with psychology and risk management. Very few new traders approach risk management the way I believe it should be approached, and very few approach psychology the way it should be approached.

For example, the concept of psychology for a lot of beginning traders seems to be about mastering the fear and greed thing, or developing the discipline to sit in front of the screen and the tenacity—sometimes being aggressive, shouting at your broker and just having that sort of trader mentality or profile made popular in the press. But psychology in my opinion is about recognizing the biases in your method, it’s about being aware of what’s creeping into your analysis and what’s creeping into your trading, and there are many biases. Unless you are aware of them, you’re not going to be truly successful. Once
you are aware of them, I believe the only combative or mitigating solution is found in applying an appropriate risk management methodology. You’ve just got to expect that you’re going to be flawed as a trader because you’re flawed as a human so the only way you’ll save yourself is very robust risk management.

Let’s talk about psychology for a little bit longer before we go on to your risk management model. How important is psychology to trading?
I don’t like to segment it, but it’s either number one or two.

A lot of Mums and Dads find the topic of psychology not appropriate to trading. Whilst I personally disagree with that, how can a retail trader grasp the importance of psychology?
I don’t know how they can grasp it but I know why they can’t. It’s because people are attracted to financial markets believing it offers some sort of diversion. Markets and trading are generally perceived to be exciting or elitist in some ways, it’s not the average occupation and therefore has some sort of status. If you can tell people that you’re a trader or you trade in the financial markets, you’re perceived to be a sophisticated investor, not just someone who has a portfolio and a broker to speak to. There’s an element of ‘freedom’ associated with the trader who doesn’t have to hold a conventional job—perhaps someone trading from home. It sounds very appealing.

The perception of what it takes to be a trader varies significantly from the reality and that’s a great part of the difficulty people have right at the beginning. The boring parts of trading are ironically the parts that will determine if you’ll be successful or not, and these include psychology and risk management. People don’t want to hear about risk management—what appeals to them is the exciting moves in the market or the potential profits they could have made if they traded the movement in question.

I think that’s also why, when people look at charts, they’re selective in what they see. We have a tendency to focus on some of the more unusual movements that we could have made the big profits on. People fail to see all the boring bits in between where they might have lost money or where their decision-making may have been adversely affected. A chart is a snapshot but a real position has to run the full gamut. All the little bits in between are what mess with people’s heads and what chop people out of the market with a less than satisfactory result. Psychology in financial markets thus is about
understanding your decision-making process and what might affect it and your results along the way. It’s very important stuff.

Two pay cheques are better than one. Learn to earn a second income.

The same could be said for an equity curve in a sales pitch. If someone selling a trading system shows a very nice equity curve then the individual is more tempted to look at the end result. What they don’t see is the workings to achieve that—actually placing the trades, monitoring the positions, the inevitable losing trades, the flat times, the drawdowns and consecutive losers. Do you think people should look at those kinds of things?
Clearly they should look at it. Whether they actually pay attention and accept it is really fundamental here.

Why don’t they look at it?
Because it’s boring. It’s not the reason they came into the market. I think perhaps for many new traders this part of trading appears incidental in many ways and because they don’t know any better it becomes unimportant to them. If you look at the literature that is published on trading and thus the introduction most new traders have to the market via books, for the most part this aspect (psychology and risk management) seems to take a back seat. Books don’t sell unless they’ve got something exciting in them or unless they’ve got something like ‘the secret of profits’, or ‘ten ways to get rich with no risk’ and so on. You can’t sell a book on something boring. It’s got to have the exciting elements in it. When people finish absorbing all that, they come into the market and that’s what they expect. It’s sadly an expensive experience for some people.

Do you think a lot of people can only learn the psychology of the markets by actually being a part of them? Can the psychology of trading be taught?
It can, I believe, or perhaps I hope so. Speaking for myself, with 14 years in the market, I guess I have to accept much of what I have learnt has come from experience but not everyone is going to have the benefit of my experiences or the safer structures I’ve had, employed by trading firms and the like. I hope psychology can be taught, as I hope proper risk management can be taught; however, it would be up to the individual. Maybe the question should be how well can people learn. If people can learn well, then I think anything is capable of being taught to them. Trading is actually a very simple game made
to look complicated. So there’s hope for traders yet. If people want to learn, they’ll achieve it if they put their mind to it.

So paraphrasing the popular Market Wizard Ed Seykota, people will get what theywant from the market. If they really want to learn and if they really want to besuccessful, they’ll actually go and do it. If they’re in it for something else, they’ll getthat instead, even if it’s a subconscious need.
I totally agree. People have to address why they’re there. I see a lot of people who are trading for their ego— they’re there to tell their mates that they’re trading, as a status thing.

People are sometimes there for the drama—there’s something powerful in the feelings we experience when offered sympathy. A losing trader can regale his peers with stories of just how bad it was. It can be impressive to those listening and this strangely is appealing to us. Maybe some people are engineering their own demise as a trader or undermining their true potential as a trader because they are actually feeding desires—subconscious or otherwise—that fill a void in their life. I don’t know. But it surprises me how many people really aren’t there to make money, even though that would seem to be an obvious
end result for them. There are many people who are there for some other reason, whether they recognise it or not—for some diversion, some distraction, to feed their perception of who they are. And they’re not going to make money.

You’re a trend follower then?
Yes, but only by default. As I said earlier, currencies are famous for trending so good FX trading means you should be riding these trends for all they’re worth. I don’t understand why people want to label themselves—contrarians, trend followers, fundamental, technical—what’s the point? There are only two types of trader that matter as far as I’m concerned: profitable or unprofitable.

Any scalping?
No, too much hard work. I haven’t got the time.

Let’s talk a little bit more on what gets you into a trade. What’s the entry mechanism?
As I’ve said, I subscribe to analysis. I used to have that analysis given to me with all manner of interpretation but it’s just opinion and opinions count for nothing in the market—not just the opinions of your broker, even your own opinion—so I just remove opinion altogether. Forecasting is a fine line between some reasonable hypothesis of what’s going to happen and pure fortune telling, so I don’t like the associated commentary that comes with a lot of analysis because it really is just opinion. The trading strategies that come to me are simple buy and sell recommendations and they live and die by the sword. Seventy-five per cent of the time they’re wrong. I need to make sure what’s coming through to me works within my risk model, to ensure the 25 per cent I get right actually make me money.

I may have misinterpreted what you’re saying here. Are you taking somebody else’srecommendations or are you actually generating signals for yourself?
I’m taking somebody else’s buy and sell recommendations. All I do with those recommendations is make sure they fit within the risk model I have devised.
Occasionally, say 20 per cent of the time, I override the recommendation because it doesn’t fit within the risk model. Let’s face it, most people are capable of coming up with a reasonable strategy for entering the market. I accept that and that’s why I subscribe to someone else’s analysis. No one makes money getting into a trade, they only make their money or lose it when they get out of it. I don’t believe I should waste a lot of my time working out how to get into a trade, when it’s very obvious all the work should be applied to getting out of the damn thing and managing the risk along the way. That’s where I put all my work.

It might be easier now to talk about the risk model.

OK. Go ahead.
My risk model requires that I cut losses quickly. I need to know the expected average loss. So if I receive a recommendation, that recommendation needs to have an associated stop-loss and that needs to be around the average my risk model will work with. It’s no use me buying something at one level and having a 200 point stop-loss. It’s going to upset everything else in the risk model and I’m going to come a cropper.

So you’re equalising your risk or attempting to equalise your risk on every single trade.If the trade is too risky you simply don’t take it?
That’s right. To a degree, I presume the strategy is a low risk opportunity. Now I can double check that myself but I have enough confidence that it remains a low risk strategy on its face value. It’s low risk for me because if it’s only a 30 or 35 point stop-loss, the market could move anywhere at any time and that’s an acceptable loss for me.

In percentage terms can you tell us how much that 35 ticks would be?
This is the other fundamental part of the risk model. I don’t risk more than 1.5 per cent of the capital in my account on any given trade. I think the average runs around 1.24 per cent. So that needs to work in conjunction with the amount that’s being lost on average, which I think I mentioned earlier was about 33 points.

What then is your rule to move your stop to break-even?
I’ve been asked that question before and I wish I could apply a rule for it but I can’t, I just use common sense and experience. It’s easier for me to make a judgement call on when the stop-loss gets pulled to break-even. In other words it’s a discretionary decision. That aspect is discretionary and so is the exit level but it’s still common sense.

My rules are simple:
1) Preserve your capital at all costs—don’t risk more than 1.25 or 1.5 per cent on any given trade.
2) Don’t pull your stop-loss past the break-even level. Doing so does nothing to assist rule one and it only increases the chance of booking a small profit, which will demote you to intermediate trader status before eventually wiping out your account.

The rest relies upon common sense. I know what my target is, my average loss and profit, my win/loss ratio, and I can keep it all in my head reasonably well throughout the trading week. I update and monitor it all in an Excel spreadsheet.

If I’m in the money 80 points on one of my positions, I know I can’t take profit until it’s 130-plus, so to feed my ‘human’ craving to do something I move the stop-loss to breakeven.

People say ‘Why don’t you move it past break-even (‘trailing the stop’) and at least protect some of the profit that you’ve got?’. That line of thinking feeds our desire to prove ourselves right. I would encourage people to avoid feeding this desire when trading. Getting it ‘right’ is not the objective. Finishing the year in profit is the goal. The FX market will drive you mad or turn you broke if you just focus on getting it right all the time.

I guess I look at it this way: if I know I’m losing 75 per cent of the time and my average loss wavers around the 33-point level, then taking a 40-point profit won’t cut the mustard at the end of the year. I’m in it to make money, not prove myself right with every trade. I started the trade with nothing anyway so I’d rather go with nothing and scratch it, but most importantly I have to give myself every opportunity to run that trade into a large profit.

Raising my stop-loss level past break-even doesn’t do anything more for my preservation of capital. All it does is increase the chance of me being stopped out for a small profit while decreasing the potential for me to stay with what could be a very lucrative trade.

You’re obviously using incredibly tight stop-losses, which is why your win rate is so low. Wouldn’t it be prudent, assuming currencies trend more often than not, to use a wider stop-loss?
It’s something I could explore but I’ve not had my trades described as incredibly tight before. It’s also a factor of the risk I’m comfortable with. I have to keep my initial risk down to less than 1.5 per cent and the tight stop-loss helps achieve that. While I have observed and hold the opinion that currencies trend very well, it’s not a safe assumption to presume the currency you’re trading at any given time will trend in the right direction once you’ve established a position, indeed if it will trend at all. If you widen the stop-loss to an amount that exceeds 1.5 per cent, you’re a gambler—you’re gun slinging and the
probabilities will eventually come back to haunt you.

Let’s put points in layman’s terms just for the readers and use the Australian dollar—33 points is…
The difference between 0.5550 and 0.5517 is 33-points. The AUD/USD is quoted to four decimal places. The minimum move is 0.0001 and thus, 33 points is equal to 0.0033. If you multiply this number by the amount you’re trading, you will arrive at the USD dollar amount of 33 points. (For example, 0.0033 % 1,000,000 = USD3,300.) It may seem like it’s a tight stop-loss to some people but it does the job for me. It’s about cutting my losses very short, having a minimum amount of exposure in an adverse move. I’m more interested in small losses and the fact that I’m completely in control of them. When the
market is ready to move in my favour I simply allow it to do so.

What happens then?
The trailing stop goes to the break-even. It will never go past the entry level.

Even if you have a position on for six months and the Australian dollar has moved from 51 cents to 57 cents, your stop is still sitting back there at your entry price?
Well it’s an extreme example, but yes. I tend to trade on a much shorter scale though. My profitable trades seem to take between five and ten days to realise and the losing trades are simply knocked out within 24 hours.

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Is taking profits a discretionary decision as well?
For me, yes—I think it’s scary that people use technical signals to get out of the market as well as into the market. It’s hard enough to pick the entry level as it is, so why double up the effort on the exit? It can only lead to frustration and it feeds the need to prove oneself right urge doesn’t it? You can look at any graphs going back weekly or daily (which are probably more reliable) and see that 600 or 700 point moves are reasonably common throughout the year, but beyond that, they’re uncommon. I keep my eyes open for the chance of a long move but overall I’m content to operate taking the easy meat in
the middle.

Does that approach change for every currency you trade?
The Japanese yen has an inclination to trend better than most currencies, whereas something like the British pound has been quite choppy in more recent times. Do you look for different profit targets or movements with each currency?

Firstly, I don’t think it’s possible to say with any certainty that any particular currency pair behaves in a certain way. It might be possible to observe or deduce a behaviour but one should be very aware of the biases that I mentioned earlier that may be affecting you and allowing you to arrive at such a conclusion. That said, my answer is yes, my discretionary approach to running a profitable trade changes dependent upon the currency-pair I’m trading. That’s where experience comes into play. I feel much more comfortable holding my 250 point profit in the dollar/yen in the expectation that I might get another 100 or 200 out of it than I would if I was trading the AUD/USD. There’s no defined rule for each currency, and it’s just discretionary on my part.

Let’s just go back to your entry method. You said you get signals from a third party. Is that a broker, a private analyst or some type of consulting firm? What gave you the faith to take their advice?
An ex-bank trader admittedly (which I would ordinarily run a million miles from); however, the analysis is a commercial operation he has founded with two other partners. Their approach to the market is sound in as much as it fits neatly within the risk model I have developed. The risk model is updated weekly, whereas it used to be updated daily when I was building my confidence in it. I’ve got to say Nick, if subscribing to someone else’s analysis seems surprising to anyone reading this interview it is in part because they might be presuming that the skill in trading is in forecasting a movement and picking a level to trade at. My method of trading does not rely on a forecast or the ability to predict a movement successfully.

Trading successfully is about assuming a position, managing the associated risk and then running the good trades for all they’re worth. Anyone who might read the transcript of this interview who believes trading successfully is about predicting which way the market is going to go next, and placing a trade accordingly is going to have trouble accepting much of what I’ve said. If people ask me my opinion where the AUD/USD might go, I often answer I don’t care which way it goes, just so long as it goes. This is because I need the currency to present opportunities to trade on as well as an opportunity to run any
resultant position for a good profit. Up or down, it doesn’t matter. One other thing about subscribing to analysis, and what surprises a lot of people, is
reliability. You’ve got to go with a reliable vendor of the analysis. There are plenty of companies around the world sending out buy and sell recommendations or other forms of analysis, and I guess I’d encourage people to find what works for them.

Can you define reliability?
Taking external advice from someone who only gets it right 25 or 30 per cent of the time, in normal thinking anyway, is not someone who’s particularly reliable. I mean reliability of delivery of that recommendation, not its win/loss rate. Are you going to get this advice at one in the morning or on an ad hoc basis? Are you going to actually be able to use it? A lot the professional analysis I have evaluated over time gives sporadic information throughout the day. Can you really work with something around the clock like that? For me, the analysis has to come at a set time so its content fits with my style of trading. I haven’t got all day to sit around waiting for something that might arrive at any moment, and I want to enjoy my sleep at night too.

How many trades a month would you do?
I think it’s about 30 trades or so per month.

Let’s talk about your trading regime.
I get analysis twice a day and I place any trading strategies directly into the online system that I use and this takes about two minutes. On Saturdays I update the (Excel spreadsheet) risk model and make sure all is well. In the interim I know the trading strategies I’m getting are roughly fitting within the risk model. If there’s anything in the strategy from the analyst that I don’t like, I just leave it out. There are plenty of trades out there in the world and I don’t beat myself up if I miss a good one for whatever reason. So the only ‘trading’ work I do every day is about five minutes, although the risk model
work can take substantially longer—kind of like doing the company accounts if you’re running a business.

My day is probably very unlike many other traders, simply because I like a set-and-forget strategy. I don’t like all the noise that comes in the market. Many people seem to think trading is about staying glued to a screen all day. If you want to stay glued to the screen, fine, but I’ve seen those people come and go, shell-shocked and exhausted. I know it would exhaust me. I try and keep my trading as simple as possible. I should also point out that my trading regime does not consist of reading the financial press because I feel that the way information is given to the public, the trading public, contains one of those biases, so to speak, that affects how people trade. We now live in a society where, really, speed of delivery of information is valued over and above the
quality of the information we get and that’s propagated by the popular data and news vendors. People new to trading think they’re only going to be successful if they have headline news screaming out at them all day but the quality behind most of what I see is just awful. Who would make a serious investment decision off the back of some news article? I think journalism is about attracting attention, not helping traders.

Do you read any of the mainstream magazines or financial press?
I do because it’s important to be conversant with the other traders I enjoy speaking to on a daily basis and I need to know what issues they’re looking at. Whether I agree or not is a different thing and I don’t let any interpretation interrupt my trading day. I know most of my decisions are extremely unlikely to be influenced by something like that, because I have a set-and-forget strategy and I stick to that strategy.

What equipment do you use? Do you trade over the internet? Do you use a specific broker?
Yes to all of that. I use an internet broker because they’re fairer than the traditional human-based broker services. The really good ones are transacting so many thousands of trades per day that human interference is unlikely. They’re not commission-driven either and they make their money from adjusting the size of the ‘book’ value of the trades they’re holding as customers deal with them. Execution may be just 5 per cent of the trading process, but it may as well be efficient and fair. An online system does that for me.

Do you leave stops in the market at all times?
Absolutely. I also leave in my profit targets most of the time.

Even if there’s some kind of freak intervention by the Bank of Japan, or other central bank?
Hindsight is the only way you’ll see that but I can live with that. Sure I’ll be disappointed because I may miss out on a large move after taking a profit ‘early’ but at the end of the day my trade objective was still met. As long as the objectives are being achieved I’m happy.

How do you measure your performance?
I think performance is measured ultimately by the return you’re getting. I look very much at the percentage return on capital, return on risk. I like to have a profitable year, and that’s the ultimate barometer of performance. Everything else along the way is just making sure I travel between A and B within acceptable risk limits.

Do you set yourself goals every year?
I have a goal to be profitable every month but ultimately it’s the market that dictates that. I’m not going to be able to stop ten losing trades in a row, which could just be how the cards are dealt that month. What I am able to stop is any self-doubt because my risk model will take care of drawdowns when they occur. Mentally, I’d like to have every month a profitable one but I can’t control that.

You just take what the market gives you?
You have to. It’s like just about everything in life isn’t it? The measure of ourselves as human beings is how we react to things. We all get dealt a lousy hand at some stage in our lives and some of us deal with it well while others complain and moan. Trading is no different—it’s a great metaphor for life. You can accept the dog trades with good grace and get on with it or you can beat yourself up about it and blame everything and everyone around you. People with a winning attitude to life will take a winning attitude to trading and it can make all the difference.

Some people I’ve interviewed work backwards: they set themselves a goal of making X dollars per year and they set their position size base to make that.
I can see why people would do that, particularly if one of the goals they have is to earn a living out of trading, but that’s not how I would approach it because it seems to me to discard the assessment of risk. That’s a presumption of course, so I should just say that I think it’s important when determining the size you want to trade that you also consider the impact this has on the capital in your account.

What do you think is the minimum amount of capital a retail trader should start out with?
At least $50,000 and if you were doing that you’d be trading at a minimum position size available to you. Like any business, and trading should be treated like a business, most traders fail if they’re undercapitalised. If we go back to my philosophy that it’s all about losing and losing well, you’re going to need the capital to not only fund your positions but also to absorb these losses along the way to eventual profitability.

What other reasons cause traders to lose?
I think people concentrate too much on the exciting aspects of trading, such as entries and profit targets—it’s what is sold to them by books and trading courses. Traders possibly also dip out, despite having the right approach, because life gets in the way: they’ve got to pick up the kids, they’ve got a late meeting with the boss, they’ve got to entertain a client and that sort of thing. I think balance in your life is important, not just for trading but for yourself generally, and how you manage your life as a person must come into play. If you’re erratic and manage your life poorly, you’re hardly likely to manage your trading life well.

What do you like most about trading?
I guess it’s a meritocracy, isn’t it? Trading won’t judge you on what school you went to. It won’t judge you on the people you know. I think that’s the most appealing thing for me and I would think for a lot of people, and that’s why I’m very happy to be a part of this business, because it’s the ‘great leveller’. Any Joe can rise to the top and I like to take that with me every single day. It also has financial rewards for me. I’m very glad to be in it and I hope to be in it for a long time. In fact I’ll be in it for as long as I want to. It won’t be the market that kicks me out, I have great faith in that. It’s allowed me many great friends, a lot of smart people, a lot of funny people. There are a lot of great stories and it’s all I’ve known for the last 14 years.

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How do you remove yourself from trading?
I have personal pursuits. I like sailing, mountain climbing and hiking, and the different disciplines that go along with them. I like the preparation that goes into a mountaineering trip or a yacht race as much as the actual event itself. I see a lot of life reflected in the market on a daily basis. I said before the market gyrations are a great metaphor for what goes on in life—I really believe it. I would never really like to get totally away from trading because there are so many great life lessons that are taught to you on a daily basis, particularly where risk taking is concerned. But I have a normal life on weekends and I go out with my friends and do ‘weekend’ stuff and trading just doesn’t become a part of it. Balance is everything.

Where do you want your trading to take you?
I think I’d like to build a legacy of some sort around my trading. Whether that’s a fund or a company completely ensconced in that or similar, and that company I think would be my goal—it should be working on its own without my day-to-day input.

Do you attempt to diversify your risk outside of your own trading by having a share portfolio or other investments?
To me that’s apples and oranges. Foreign exchange is not an asset class, it’s an exchange. Shares and property and the money I commit to building my business are risks unrelated to trading. I don’t diversify my investments across different asset classes to offset risks in my trading. My trading risks are taken care of in the approach I utilise.

Moving forward, do you think you will use your trading to feed other investments?
Definitely. The job of setting up a ‘wholesale’ foreign exchange fund is nearly complete and I expect it will be launched by the end of the year. This is an obvious extension and its operation will become a part of my existing business.

Would you change your approach in any way if you were managing other people’s money?
No, not in the context of how I approach risk management. However, administration and prudential requirements aside, I’d take a good hard look at capacity.

How do you think potential investors would view you getting your buy and sell signals or recommendations from a third party?
This is an important question but again the conflict resides with the individual and the perception that the secret of any success lies with the tool used to devise an appropriate method of entering the market. I’d like investors to know the tool that is of the most importance within my approach to trading the market is the risk model I have developed, and this is proprietary and wholly within my control. In addition, the fund will utilise multiple strategies and not be dependent upon any single source. The risk model is adaptable and if one source of analysis disappears others can take their place. The fact that I’m just using one or two as a private trader is simply a product of the account size—I don’t need more than one or two.

That aside, a lot of hedge funds don’t disclose the nuts and bolts behind their trading systems. Often the actual approach is never revealed although I’m happy to be transparent if required—I’ve nothing to hide.

Do you or did you have a mentor?
In business I do, in trading I don’t. Although I have had the privilege of networking with some very talented traders from my inter-bank career. I still stay in touch with those people and they can be very galvanising as far as motivation and they’re exciting people to be with.

A common thread coming through these interviews is that most interviewees worked in the markets to start with. Some people say that’s the worst thing that you can do. What do you think?
I would tend to agree with people who say it’s the worst thing that can happen to you because these institutions, in my opinion, really go about proprietary trading the wrong way. I should be careful here though—the FX trading banks are aware of their business flows and that’s reflected in an increase in more sales-focused foreign exchange roles, where corporate and other institutional customers are sourced to drive currency volumes through the bank, allowing them to generate an income from the FX market. But these roles shouldn’t be confused with ‘proprietary trading’ roles which is what private traders do. Proprietary roles have been decreased over the years as banks have generally become dissatisfied with the risks or disappointed with the returns. I just don’t think a bank-trading environment is conducive to developing a good proprietary trader. I draw that conclusion from my own experience working in a major FX trading bank, but this was more than a decade ago and I accept things may have changed. My company has provided brokerage services to persons who have been (or still are) institutional traders and there’s no evidence in their returns to suggest they outperform the average Joe. If I were looking to employ a trader, I’d look for one without the baggage.

For somebody who doesn’t know a great deal about the markets how do they get to where you are?
To do anything for the long term, any worthwhile cause, you’ve got to derive some satisfaction from it. If you’re interested in trading don’t make it a chore because you have a preconceived notion of what is required of you. If you think traders sit in front of screens all day and that you have to do the same to be successful—well it’s not the right approach to take.

Start by doing what’s right for you. Isn’t the notion of trading for oneself all about having freedom to be your own boss and master of your own destiny?
I would also encourage people to be aware of the risks, first and foremost, so they can get to the stage to live to fight another day. Don’t ever put yourself in a situation where you’re going to knock yourself out if you get one or a few trades wrong. If your account can’t handle 50 losses in a row, you’re undercapitalised or overtrading. Trading shouldn’t be a gamble—it might look like gambling but the successful trading operations look more like well-run businesses.

Other than that, be prepared to waste some years, I guess. Pick up the books and do some courses—they won’t all be good but they’ll help you to come to a better understanding of yourself, which is vital. And ultimately you must eventually trade. There’s no experience quite like getting into the ring for a couple of rounds. Come well prepared, however, and please—no tears. There’s no crying in foreign exchange, that’s for stock market traders.”

This has been an excerpt from Every-day Traders Australia by Nick Radge