Why Might we Auto Trade the FX Market? by David Rodriguez,
Quantitative Strategist for DailyFX.com [email protected]
& http://www.twitter.com/DRodriguezFX Summary: Major
improvements in trading technology have made Automated Trading a
real option formany investors. But what is auto trading andmore
importantlywhy might investors choose analgorithm over a manual
trading technique? Automated Trading as a concept is
straightforward: a computer uses pre-determined rules to execute
and manage trades. A surge in popularity and a revolution in
trading technology has made it more accessible than ever. We see
this as a mixed blessing: on the one hand, such opportunities were
only available to sophisticated institutional investors. Now most
investors can choose from a wealth of automated trading platforms
and systems. Yet there is likewise clear downside: many marketers
tout unrealistic claims of riches with no effort nor significant
investment. What sounds too good to be true unfortunately is, and
investors should ignore any such promises. Instead we will focus on
a major motivation behind automated trading: human psychology and
behavior. The Traits of Successful Traders Behavioral Economics in
Action We performed an extensive study on real trader behavior
which we believe highlights a key point:human psychology often
interferes with successful investing. DailyFX worked with
information on 12million real trades executed via parent company
FXCMs client data. The chart below represents asignificant finding
in real trader psychology. We captured success rates in all trading
decisions across 13 of the most popular currency pairs. The
individual investor captured profits on a decisive majority of all
trades. Success Rates Traders are Successful on Most Trading
Decisions Figure 1 Source:The data is derived from Forex Capital
Markets LLC accounts--excluding managed and EligibleContract
Participant accounts--from 10/01/2009 to 9/30/2010. All data is
rounded to the nearest whole number. Yet the next finding is less
encouraging: the average loss on each of those successful trades
was often nearly twice the size of the average gain. Average Profit
and Loss per Trading Decisions (in Percentage-in-Points) Figure 2
Source:The data is derived from Forex Capital Markets LLC
accounts--excluding managed and EligibleContract Participant
accounts--from 10/01/2009 to 9/30/2010. All data is rounded to the
nearest whole number. The data in the Figure 1 shows traders
captured profits on 59 percent of all EUR/USD trades, but Figure2
tells us that the average gain was a mere 65 points compared to a
127 point loss. Simple arithetic tellsus that traders would have to
capture profits on at least two-thirds of all trades in order to
see positivereturns. Yet we see that this is not the case, and
indeed most retail FX traders lose money. Controlling Emotions: Do
More of what is Good, Less of the Bad Viewed in such stark terms we
come to a straightforward conclusion: traders should control losses
andlet profits run. Do more of what is good and less of what is
bad. If the solution is so simple, why does it elude so many FX
traders? Clearly the speculative trader aims to turn a profit, and
low success rates should be of major concern. These results seem
irrational. Humans want to be right.We naturally want to hold on to
losses, hoping that things will turn aroundand that our trade will
turn around. At the same time, we want to take our profitable
trades off the table early because we are afraid oflosing the
profits that weve already made. This is how you lose money
trading.When trading, it ismore important to be profitable than to
be right. A simple experiment helps clarify this concept. What if I
offered you a wager on a coin toss? You have two choices. If you
choose A, we flip a coin. If it lands on Headsa 50% probabilityyou
win1000 dollars.On Tails you win nothing. Choice B is not a gamble
at all: I simply give you a 450 dollargain. Which would you choose?
Gambling on Gains is Too Risky for Many People It makes sense to
choose Choice A at every opportunityparticularly if the wager is
repeated. You canexpect to make 500 dollars with A and only 450
dollars on B. Unfortunately, most people turn risk-averse when it
comes to winning: theyll settle for the definite and yet inferior
profit. This in itselfwouldnt necessarily be a problem, but the
opposite happens when we go to a wager on losses. Gambling on
Losses is Far More Common Choice A now represents a 50% chance of a
1000 dollar loss on Heads and no losses on Tails, while Choice B
offers a definite 450 dollar loss every time. The expected return
here means Choice B should be relatively obvious: youll lose 450
dollars with Choice B versus an expected 500 dollars with Choice A.
But most people become risk-seekers when it means they can avoid a
loss; theyll take choice A. Most people avoid risk when it comes to
taking profits but then actively seek it if it means avoiding
aloss. Why? Why Can the Trading Psychology Prove So Difficult? What
drives our behavior on profits and losses? To further explore human
behavior and psychology, we look at key research on decision making
from Nobel prize-winning psychologist Daniel Kahneman andAmos
Tversky. Kahneman and Tversky performed extensive experiments with
real people to determine what drovepeople to make specific
decisions. And though it was not focused on trading decisions per
se, theapplications for trading are clear. These researchers found
that people were far more scared to lose than they were
enthusiastic to win. In trader terms: losses hurt significantly
more than gains feel good. In fact their 1979 paper found that the
equivalent loss hurt approximately 2.25 times more than the
same-sized gain gave pleasure. The chart below approximates their
major finding. They assign Pain Points for losses as well as Joy
Points on gains.Note the clearly inconsistent shape of the curve.
Losses Hurt More than Gains Feel Good a Key Risk for Traders
Kahneman and Tversky showed something remarkably simple yet
profound: making $100 instead of $50will not make the average
person twice as happy. Yet losing $50 hurts more than either of
these gains,and most will take a gamble on losses to avoid clear
mental anguish. Can you consciously avoid falling into this trap? A
purely rational trader can, and indeed theresevidence to suggest
that learning money management techniques can greatly reduce a
traders chancesof going bust1. The chart below shows how the
investors Pain/Joy curve should look in the dashed green line. A
Purely Rational Trader Can Treat Losses and Gains as Equal
Opposites Taking a rational approach to markets means treating a 50
point gain as the emotional equivalent of a 50 point loss. Our data
on real trader behavior unfortunately suggests that majority of
traders cannot dothis. We therefore need to think systematically to
improve the probability of success. Why Might We Auto Trade the FX
Market? This is where auto trading can help fill a void. Its
impossible to remove all emotions from trading, but ifwe use a
systematic approach to making real trade decisions we might improve
our chances. As we seethrough real experimentation, this can make
an important difference.At this point it is critical to go over a
simple reminder: automated trading is absolutely not the path
toovernight riches, and anyone who tells you otherwise should be
ignored. Like everything else worthdoing, successful trading also
requires hard work. Our subsequent articles will go over Automated
Trading techniques and how traders might apply theseconcepts to
their own trading decisions. 1
(https://www.michaelcovel.com/position_sizing.pdf p 20). DailyFX
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