This is how to trade like a hedge fund manager is really about the steps to developing a successful trading strategy. Having worked with many money managers and being involved in the process of launching managed fund products, I have realized that all money managers work in a similar way. Their strategies may be different, but the way they come about developing these strategies is not. The reason there are common threads is because professional fund managers need to have accountability. In other words, they need to understand their own methodology inside and out.
The difference between a professional and an unprofessional trader is that a professional never goes into a trade blindly. This is important because in order for professional money managers to be confident enough to solicit investments into their funds, not only do they need to have a battletested strategy, but they also need to know when the fund succeeds, when it fails, and how bad things can get.
As retail or individual traders, our $20,000 accounts are just as important as any $20 million hedge fund. In fact, our accounts may be even more important, because we are trading with our own money whereas the $20 million hedge fund manager is most likely trading with other people’s money. Therefore, if all hedge fund managers follow a five-step process in developing their trading strategies, there is no reason why individual traders should not to do so as well.
The best way to develop a trading strategy is to follow a five-step topdown approach:
- Properly defining the trading strategy.
- The art of entering and exiting.
- Test drive.
- Getting intimate.
PROPERLY DEFINING THE TRADING STRATEGY
Every hedge fund manager, like every trader, follows a different methodology. Some will only use fundamental analysis, while others will only use technical analysis. The first thing to do is to figure out what type of trader you are and what type of style you want to trade in. This chapter will not tell you which style of trading (fundamental versus technical or short-term versus long-term) will be the most profitable, because there isn’t one style that is best. In Millionaire Traders: How Everyday People Beat Wall Street at Its Own Game (John Wiley & Sons, 2007), we interviewed 12 successful traders from all walks of life and learned that there isn’t just one way to trading success. Every trader is different; some would hold positions for weeks and months, while others would hold them for mere seconds.
There are four key things that you need to think about when defining a strategy, and these need to be done before you start trading. Trade with a plan and do not develop that plan on the fly.
Fundamental or Technical?
The first step to defining a trading strategy is to figure out whether you want to trade based on fundamentals or technicals, or a combination of both. When fund managers develop systematic trading strategies, clear-cut rules are developed so that they can be coded. Although not everyone will be coding their trading strategies, there is a lesson to be learned from that process, as one of the primary reasons traders fail is because they get too emotional. Coming up with your own rules is extremely important, because following rules takes the emotion out of trading. Figuring out whether you want to base your trades on news or a technical indicator is only the initial step to defining your trading strategy.
What Currencies Will You Trade?
The second step is to determine which currency pairs you want to trade, because not all currencies are created equal. In FX, there are generally two types of trading strategies—trend following or range trading. Most hedge funds are trend following because of the one-way directional bias of the currency market, but many people are contrarians by nature and may choose to range trade instead. There is no wrong or right choice, but in order to increase the probability of success, many hedge fund managers will narrow the currency pairs that the system will trade. Rarely have I seen professional traders apply the same strategy to every single currency pair. They will almost always have currency pairs that they trade often and currency pairs that they never trade. For example, if your trading strategy calls for a risk of no more than 100 pips on each trade, currency pairs with wide ranges like the GBP/JPY and the EUR/CAD should be avoided and probably not traded, because even if the currency pair eventually moves in your desired direction, its wide swings may stop you out before doing so. Another example would be to apply range-trading strategies only to range-trading currency pairs and apply trending strategies to trending currency pairs. The CHF/JPY, for example, is a great currency pair for a range-trading strategy and a horrible one for a trend-trading strategy, because except for one spike lower, it has been trapped in a 300-pip range from September 2007 to March 2008. Therefore, a person with a range-trading strategy should look to trade only currency pairs like the CHF/JPY, while trend traders should avoid the CHF/JPY at all costs.
When it comes to currencies, another thing to consider is majors versus crosses. Major currency pairs such as the EUR/USD or the USD/JPY tend to be very sensitive to what is happening in the U.S. dollar, whereas this is generally not the case for the crosses, because they do not include the U.S. dollar. News traders may find this tip particularly useful, because unless you are trading U.S. data, crosses could actually be better bets because their price action may be less distorted by the market’s appetite for U.S. dollars.
What Time Frame Will You Trade?
The third step to defining your trading strategy is to determine what time frame you want to trade. A strategy that works on a daily chart will probably have far less accuracy on a 5-minute chart. For example, if you are using the inside day strategy, you will see that inside days are far more common on intraday charts and far less common on daily charts. This is why they are extremely accurate when they do appear on daily charts; the rarest things can be the most valuable. Finally, when it comes to time frames, other things that need to be considered include whether you will hold positions overnight and over the weekend. For example, short-term traders may find it more profitable to close their trades if they are not working after a certain number of hours or when the market switches into the Asian trading session. This would apply for traders reacting to news, because if the trade does not move in your favor after a few hours, the momentum from the news release has probably waned. As for the weekend, occasionally something big may happen between Friday night and Sunday afternoon. Unless you have stops that can absorb any shocks or you know that there isn’t a significant event risk, closing positions before the weekend may also be something to consider.
THE ART OF ENTERING AND EXITING
In an interview for Millionaire Traders: How Everyday People Beat Wall Street at Its Own Game, Rob Booker made a fantastic analogy. We were talking about whether the entry of a trade or the exit is more important, and Rob likened this to flying and asking a pilot which is more important, the takeoff or the landing. Without even needing to ask a pilot, as passengers, we will all agree that the same degree of precision needs to be applied to both the takeoff and the landing. This is true for trading as well.
The majority of traders spend their time trying to figure out the best entry strategies by looking for the perfect combination of indicators for buy and sell signals, while their exit strategies are usually relegated to being nothing more than an afterthought. Yet this afterthought often is what differentiates consistently profitable traders from ones who are perpetually looking for a better trading strategy. Too often have I heard traders complain about how they let a winning trade become a losing one.
When hedge fund managers design trading strategies, they give a great deal of thought to both entries and exits. There are primarily four different ways to enter or exit a trade:
- Single entry, single exit: With a single entry and a single exit, traders basically put on their entire position at one price and exit the entire position at one price.
- Single entry, multiple exits: With a single entry and multiple exits, traders enter their entire position at one price but scale out of the position at different prices. This tactic is usually used to ride a breakout or trend for as long as possible while banking some profits along the way.
- Multiple entries, single exit: With multiple entries and a single exit, traders scale into a position at different prices but end up closing the entire position at one price. This tactic is used by traders who are averaging down and averaging up. To average down means to add to a position as it moves against you with the hope of attaining a better average price. To average up means to add to a position as it moves in your favor.
- Multiple entries, multiple exits: With multiple entries and multiple exits, traders scale both into and out of their positions. This is a tactic frequently used by trend traders. They average up into a position by adding to winning trades and scale out of the position to capitalize on as much of the trend as possible.
With automatic systems, entry and exit strategies are set in stone and coded into the system. Traders should try to approach entries and exits in the same way by deciding which of the four combinations to use before laying on a trade. For those traders who like to average up or down, an important question to ask is how low or how high you are willing to buy. If you keep on adding to a losing trade, at some point it just becomes smarter to bite the bullet, take the loss, and admit that the move you were initially looking for will not happen or the trend has changed. A good rule of thumb is to average down no more than three times. When it comes to stops, there should be no art involved—have a set rule on placing stops and stick to it.
You will never buy a car without test-driving it, so you should never trade a strategy without back-testing it! For hedge funds and developers of automated trading systems, back-testing is extremely important because if a trading strategy did not make money in the past, how can they believe that the strategy will make money in the future? Many FX traders will learn strategies from their friends, trading coaches, or even this book, but no one should ever just follow a strategy blindly. Make sure it is back-tested and forward-tested.
For traders who are particularly good at programming, code your strategy using something like TradeStation, eSignal, or Meta Trader, run the results, and make sure that it is profitable.
Traders who do not know how to code should do the visual back test. Open your charts, apply your indicators, and look for a minimum of 20 examples of the strategy working. Then downgrade the time frame of your charts to make sure that the strategy could have been executed at your desired price. For example, if you are trading a strategy based on hourly charts, make sure there are no spikes on the 5-minute charts.
Once you have found your back-tested examples, it is time to forwardtest. One of the great things about trading currencies is the wide availability of demo and mini accounts. It is important to live test with a small amount of money, because once there is actual money involved, a whole different set of emotions will arise, and controlling those emotions is an important part of developing the discipline you need to trade larger amounts of money. The best thing to do is to focus on the changes in pips and not the changes in dollars.
The fourth step to thinking like a hedge fund manager is to get intimate with your trading strategy, because not all trading strategies are alike.
When it comes to performance, there are two primary types of trading strategies—one that has a high percentage of profitable trades and one that has a high profit factor.
In strategies that have a high percentage of profitable trades, usually the amount of pips made in winning trades is approximately the same as the amount of pips lost in losing trades. An example would be a strategy where 8 out 10 trades are winners, with each winning trade making 20 pips and each unprofitable trade losing 20 pips. Although this does not satisfy the textbook description of a good risk-to-reward ratio, if the number of profitable trades is far higher than the number of losing trades, the strategy is still a solid one. In the previous example, the net profit for the 10 trades would still be 120 pips. Therefore, if you have a strategy similar to this and it starts to have six or seven consecutive losers, you know that it is time to seriously reexamine the strategy.
For strategies that have a high profit factor but a low percentage of profitable trades, having a string of losers may be a part of the trading strategy. This applies particularly to breakout traders who may take small positions with tight stops in anticipation of a big breakout. Although they may get stopped out often for 30 or 40 pips, when the breakout occurs, the eventual move could be to the degree of 400 or 500 pips.
The key here is to know exactly what type of market environment your strategy performs well in and what type of market environment your strategy fails in, because only then will you know when it is time to pull the plug.
In the currency market, managing losses is extremely important. Many people who are new to the currency market argue that trading FX is far more dangerous than trading any other asset. In some ways they are wrong and in some ways they are right. With only eight major currencies to trade, the FX market is much easier to understand than other markets. Also, since most people trade only the G-10 currencies, economic data cannot really be manipulated and there will almost never be a scenario like WorldCom or Enron. On a day-to-day basis, currency rates usually move no more than 1 to 2 percent, which actually makes them one of the least volatile assets to invest or trade in. However, the availability of very high leverage does make trading currencies more dangerous. Some brokers offer as much as 400-to-1 leverage, which makes a 1 percent move more like 400 percent. It therefore becomes much easier to blow up your trading account. Thankfully, leverage is customizable, and it is important for traders to actively manage their risk.
Understanding the drawdown of your trading strategy helps to manage risk by giving you a frame of reference for determining when to pull the plug and when to sit tight. A drawdown is defined as the reduction in account equity from a trade or series of trades. All professional money managers know the maximum drawdowns of their trading strategies. For example, I once tested a strategy involving carry trades, and the maximum drawdown for the strategy over the past 10 years was 15 percent. With that number in mind, I knew that if the drawdown going forward hits 10 percent, it does not necessarily mean that the strategy has failed. However, if the drawdown hits 15 percent I should start getting very worried; and if it hits 20 percent, then I know that this may be a completely new trading environment not previously accounted for in the back test, and for that reason, it may be time to seriously consider pulling the plug, admitting that I am wrong, and terminating the strategy.
When it comes to drawdowns, there are three main things that all traders need to know about their strategies. The first is the average drawdown on a given trade; this is important because it lets you know whether the trade is behaving in accordance with your strategy. The second is the degree of the biggest drawdown; this lets you know how bad it can get. Finally, you need to know whether the drawdown is on a closing or an intratrade basis. Oftentimes the drawdown or maximum loss on a closed trade may be different from the drawdown or floating loss on an open trade.
The last step of thinking or trading like a hedge fund manager is selfreflection. A few years ago, after I conducted an FX trading workshop in Malaysia, a trader came to me for advice. He told me that he had a trading strategy that worked well in nearly all market environments except when news was being released. Interestingly enough, he asked me what I thought he should do, and I simply said, “Don’t trade when news is being released!”
Oftentimes we become so absorbed with trading that we do not notice the obvious. This why it is important to spend some time on a weekly or monthly basis to go over or reflect on your trading. At the end of every week, Boris Schlossberg, with whom I run BKTraderFX, and I will sit down and go over each and every one of our trades. We will ask ourselves why a particular trade worked, why it did not work, and what we could have done better. We will review both the winning and losing trades to look to find room for improvement. In fact, with every trade that we take, we will ask ourselves if this is in line with our trading strategy, and if not, will we end up regretting making the same mistakes at our end-of-week review sessions.
For the trader in Malaysia, the small improvement that he needed to make may have simply involved avoiding news releases, which can be applicable for range traders in general. Other people may realize that they are taking profits too early or find that their performance improves by limiting their trading to certain times of the day. Small and simple changes such as these can make a long-term difference for all traders.