Fusion Markets

Albert Einstein was once asked what the most powerful force in the universe was. After a thoughtful pause and not without a sense of humour, he replied that it was compound interest, which he would later describe as being the world's eighth wonder.

If we were looking for a candidate to fill the number nine spot on that list, we could easily pick another innovation from the world of finance; leverage.

If we look at a dictionary definition for the term, we find the following.

"The use of credit to enhance one's speculative capacity"

The concept of financial leverage is probably most familiar to us in a mortgage loan, a loan secured against a property.

To secure a mortgage, it’s normal for the buyer or buyers of the property to put down a deposit that acts as their “skin in the game”.

A bank or other lender finances the purchase price balance through a loan that runs over a fixed term, usually measured in 25-30 years.

This is made at a known or referenced rate of interest, which may be fixed or variable over the loan term. For example, the rate may be set at central bank base rates +X%.

The buyer of the property finances the loan through the payment of interest, which compounds over time to make the lender a healthy return on their loan, assuming all goes well.

The ever-present longevity of a mortgage and the nature of its commitment can be summed up through a literal translation of the word mortgage from the French, where it means “death pledge”.

Of course, that rather sombre definition only looks at the liability side of the transaction. It doesn’t take into account the opposite side of the coin, and that is the asset that the mortgage is taken out over.

All things being equal, the asset will have appreciated over the lifetime of the loan. And in modern times, it will have often done so to such an extent that its value now exceeds the loan's original value.

Under those circumstances, the death grip is loosened and may even be released completely if the property’s owners choose to sell it and repay the outstanding mortgage balance.

That’s all very interesting, but what has any of this got to do with trading and investing?

Well, just over 20 years ago, traders in London had the great idea to introduce leverage into OTC financial instruments such as CFDs and rolling spot FX.

This effectively democratised the availability of leverage in trading by providing it to the man in the street who could now gear up their trading account and speculate on the markets in a way that wasn’t possible before this point.

The availability of leverage in margin FX and CFD trading was a marketing team's dream. A whole new industry sprung up to offer these products (which had previously been the preserve of hedge funds) to retail traders.  

Eventually, competition for that business was such that brokers began to raise the levels of leverage that they offered to their customer base.

Put simply, that meant that traders could control an ever-larger parcel of stock, an equity index or FX pairs with a smaller and smaller deposit, which brings us to today.

It all sounds great. Because, of course, if your position was leveraged 500 times, then so was your P&L. A dollar profit became 500 dollars.

Well, not so fast because leverage is a two-way street that magnifies profits and losses.

And whilst leveraged positions in profits create equity in your account, leveraged positions that are in loss eat away at your account balance and ultimately undermine it completely.

Events in the spring of 2021 highlighted exactly why traders need to respect and control their use of leverage, and the consequences of not doing so could not be clearer.

Bill Hwang of Archegos Capital Management, a hedge fund turned family office with $20 billion in assets, effectively evaporated overnight thanks to a combination of risk concentration and excessive leverage.  

Put simply, the fund had too much money chasing too few positions.

You might have thought that having $20 billion to invest would mean that you wouldn’t need access to leverage, but Archegos Capitals strategy was to leverage that vast sum by as much as 7x times through a network of banks and brokers. The trick was that none of these banks knew just how much leverage the other parties had offered Archegos.

But no one, not even a hedge fund of that scale, is bigger than the markets, and when some of these positions fell in price and value, the fund’s brokers asked for additional margin to shore up its trading accounts.

By this stage, the banks were concerned about their own liabilities and whilst they were talking to each other about they should proceed, one or two of the banks started to try and close out the positions they held for the hedge fund.

Once word got out that this was happening, it became a free-for-all, and the stocks that Archegos held plummeted. And that, of course, created even larger margin calls that the fund had no hope of meeting.

Below is Archegos' biggest positions in their fund and how quickly things folded within a couple of days after the music stopped. ViacomCBS, a respected US media company, fell by over 50% in 2 trading sessions.

These events reinforced another lesson for traders - the one that says the end of the party is never pretty if everyone heads for the exit simultaneously.

It also reminded us of how an imbalance between supply and demand can influence prices (Gamestop or AMC, anyone?)

You probably haven’t got $20 billion, but you do have your nest egg and trading capital that you worked hard to build up. Please don’t blow it by leveraging and concentrating your risk in one or two big positions.

A disciplined approach to money management and risk is the key to successful trading and investing. When you don’t use that disciplined approach, it often goes horribly wrong, as the former Hedge Fund Archegos Capital found out.

That’s a question that has dogged professional investors for years.

Picking investments or trades to buy is one thing but when it comes to selling and in particular timing a sale its a whole different ball game.

In retail trading circles, this can cause us to snatch at profits and to run losing positions beyond the point where our money management rules tell us we should have closed the trade, with predictable results. It's a clear form of loss aversion (a cognitive bias that we should all be aware of) that stops us from making the rational call to close the trade.

Success in trading comes from running profits and cutting losses to grow our capital base and the ability to do this repeatedly, over as long a period as we can manage.

Having trouble selling isn’t confined to private investors, however. It’s a real issue among professional traders and money managers, unlike the science of buying or investing, which has been scrutinised to death by academics, analysts, traders and other financial markets participants. The science (or should that be the art of selling or divesting) has had precious little coverage in comparison.

The widely respected Barons magazine recently highlighted the asymmetry in professional money managers' selling ability and why professional can vastly underperform the market benchmark.

A research paper written by a mixture of US academics and specialists who measure investment performance or “skill “ as they like to call it, looked at 4 million trades made by money managers between 2000 and 2016 across 800 portfolios that on average contained more than USD 570 million of assets (aka "smart money").

The researchers found clear evidence of skill when entering trades or positions on the money managers' part, but it was a completely different story when it came to exiting trades.

In fact, the research found that the money managers were frankly shockingly poor when it came to timing sales, selecting what to sell and when to sell it. The researchers estimated that this lack of selling ability cost the managers returns of 2% per annum. Whilst that might not sound like much in insolation, if we consider the effects of compounding over decades that underperformance becomes hugely significant.]

That point is further reinforced by research by asset managers at JP Morgan Chase in 2014.

The fund managers looked at the lifecycle of 3000 US stocks dating back to 1980 what they found was striking as the quotes below show.

Risk of permanent impairment

“Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak value.”

Negative lifetime returns vs the broad market.

“The return on the median stock since its inception vs an investment in the Russell 3000 Index was -54%. Two-thirds of all stocks underperformed the Russell 3000 Index, and for 40% of all stocks, their absolute returns were negative.”

Trades have a finite life cycle, and for the vast majority of stocks (or choose your asset class), they will often have their moment in the sun, get too close to it, and then fall away, never to return to those levels again. Identifying trades at their peak or going past their “sell-by dates" couldn’t be more important to an investment portfolio's performance.

In light of this knowledge, what can we do?

As with all the biases and psychological blackspots in trading that we discuss in our articles knowing and acknowledging that they exist half of the battle because we can modify behaviour accordingly once we have done that.

As traders in cash-settled margin products, we have an advantage over the money managers and asset owners described above. Simply because we are used to going both directions, e.g. shorting, on asset classes such as currencies and metals.

We take a 360 degree or holistic approach to the markets and the skills we use to decide to short USDJPY or the US 500 index can also be used to determine when a long position has run its course. Conversely, the skill set we use to identify a trading opportunity on the long side should also tell us when a short position is running out of steam.

Most traders we know of at Fusion do not hold their trades for more than a couple of days. Due to the power of leverage, they often don't need to since the gains can be enormous (but so can the losses we leave to run far longer than any positive P&L).

At the same time, why not make use of take profits or trailing stops to make sure you can squeeze that little bit extra out of the profit on the trade or set your levels and stick to them, without checking your phone or platform every minute of the day as we all do.

By adapting our mindset and the trading skills that we developed around opening trades, we can become better sellers or closers of positions and that will help us get the most out of the trades we make and the positions we take.

New and novice traders spend a lot of their time worrying about how they will recognise and spot trading opportunities as they occur, and what will be the best way to exploit them when they do. They can spend hours researching and reading, looking at charts and trying to apply technical or fundamental analysis to the current market setups.

That investment of time and effort on their part is commendable, but all too often it's time and effort wasted!

It may seem harsh to say that, but here at Fusion Markets, we believe in telling it like it is.

We say that it's time and effort wasted because, despite all the research, reading and studying of charts, many newbie traders will still put the wrong trade on and more to the point not realise they are doing so.

Driven by sentiment

Financial markets are primarily driven by sentiment and momentum, which itself is created by crowd behaviour. That's something that was identified and put into print as long ago as 1841 and though the technology of trading has changed considerably in the intervening 179 years, the psychology of trading hasn't. 

We could go as far as to argue that while there is no longer a physical crowd on a trading floor or exchange these days, there is, in fact, a much bigger crowd whose voice and actions are amplified by modern communications. Real-time information through social media, for example, can enable the instantaneous exchange of information, prices and views across the globe.

The transfer of information 

There have always been communication channels between markets and their end customers, of course. But it is the speed of modern networks that differentiates today's trading from what went before.

Flags and telescopes on high towers, carrier pigeons and messengers all played their part in the transfer of information. Those methods were superseded by the telegraph, which in turn was replaced, at least partly by the telephone. The internet, the world wide web and the rise of mobile telecoms have ushered in a new age of high-speed data that can reach almost any corner of the globe, at the same time.

The net effect of all this is that the trading crowd is much larger, better informed and able to act and react much quicker than ever before.

Weight of money 

In trading, the majority rules, in that markets move in the direction that has the most impetus. If most of the crowd is bullish, then demand outweighs supply and prices will rise until fresh supply (sellers) are attracted into the market. This is why people go on about what the “Smart money” is doing. While we don’t necessarily agree with them being “smarter”, they certainly have more capital!

Conversely, if supply outweighs demand, that is there are more sellers than buyers to satisfy them, then prices will fall as new buyers are drawn into the market.

If these price changes persist for any length of time, they form what is known as a trend which is nothing more than a series of continuous, repetitive movements in price.

It's not only modern communications that have amplified crowd behaviour and sentiment.

The rise of tracker funds, ETFs and other passive investment vehicles have also played a role. These types of investment don't try to beat the market. Instead, they aim to match it.

Trillions of dollars have flowed into these trackers over the last decade and a half, and indeed you could argue that they have become so successful and so large that ETFs are now capable of creating the market's trends rather than just following them.

In fact, the world's largest fund manager is also one of the world's biggest passive investors (Blackrock).

Passive FX trading  

The influence of tracker funds is not as prominent in FX, as it is in say, equities or bonds; however, the principles are the same. The crowd dictates the trends in the markets and those trends tend to stay in place until new information emerges and cause a change in sentiment, which in turn can cause a change in those market trends.

Now the big mistake on the part of newbie traders that we mentioned at the start of the article was putting on the wrong trade, typically by opposing the prevailing trends in the markets.

The more entrenched the trend, the more likely new traders, are to try and oppose it. Ever heard the saying “trying to catch a falling knife”?

How can we become passive traders?

The most obvious way to be a passive trader is to follow the existing trends in the FX market, which occur in even the most widely traded pairs. Nevertheless, here's a few ways you can become more passive. 

For example, EURUSD trended lower for almost two years between February 2018 and February 2020. You didn't have to stay short of the rate (that is, have sold the Euro and bought the Dollar) for two years to benefit from that move. As long as that downtrend was in place, it was pointing you in the direction of least resistance and with that being the case why would you oppose it?

1) Check your charts.

Sometimes you will be able to follow existing trends, but there will be other times when individual instruments or markets are ranging or moving sideways, checking your charts and knowing your levels can aid you here.

A chart can speak a thousand words. It contains loads of useful information that's conveyed visually to the viewer. Get to know where the key support and resistances (watch for breakouts too) are situated over daily or weekly timescales; shorter-term charts are too noisy (I’m looking at you, 5-minute chart!).

2) Know where key levels and moving averages are.

The way that price reacts when it meets moving averages, or support and resistance can dictate the direction of the next trend. Knowing when and where this can happen will put you on alert to "jump" in once a new trend is confirmed. Fusion puts out trade ideas and analysis on Telegram and Facebook.

3) Look for clues about trends in sentiment tools

Tools that track what traders are thinking and doing are incredibly useful.

Given what we said above about retail traders opposing market trends, the passive FX trader uses these sentiment reports as reverse indicators.

We quite like FX Blue’s sentiment indicators which you can find here

The rule of thumb is that the more biased retail trader sentiment is in an instrument, the more likely that the market will move in the opposite direction.

A passive trader wouldn't preempt that move, but they would be prepared for it when it happens, or join it if it's already begun. 

After all, one of the most famous quotes in the markets is "the trend is your friend"... So don't fight it.  

When you start to learn about trading, you'll come across plenty of material about minimising risk and money management, because they're two of the most critical areas of the business. 

Learning to manage risk and preserve trading capital is fundamental to a successful trading journey. 

One area the literature focuses on is the use of stop losses. A stop loss is simply a price level beyond which you choose not to run an unprofitable or losing trade.

But for me, stop losses are one of the most misunderstood tools in a trader's arsenal, and I wanted to offer a different perspective than what is usually found in the research.  

I'll give you a hint; it's in the name!

Knowing your risk

It's important to know the risk you are taking on any given trade, this can be calculated by multiplying the distance of your stop loss, from the entry-level of your trade, by the notional size of your trade.  

In theory, this simple calculation determines the maximum risk or loss that you face on a given trade. I say in theory because that risk figure is not cast in stone.  

Firstly, if the stop loss you use on a trade is just a mental one, i.e. a figure that you have chosen, (but will watch rather than attach to an order), then it will be down to you to monitor price action and trade it. That's a sure recipe for looking like a maniac checking your platform or mobile app every second you get.

Systemise your process

Rather than rely on them being in front of the screen to close a trade (which in a 24/5 market is not that realistic), many traders will place a stop loss to an open position. This is essentially creating an instruction to close the position should the price of the underlying instrument reach a pre-set level.

In doing so, traders are systemising this part of their trading. On the face of it, that sounds like a good idea doesn't it? 

But what if that automated stop loss level was defining the loss you make on a trade and eating away at your trading capital, not protecting it?  

The use of a stop loss should be what its name suggests – the prevention of a loss, not the realisation of losses as 90% of traders currently use their SL for.  

Crowding together

Here's the thing. Traders of all sizes fall foul of "clustering" which means they place their stop losses in the same areas, at the same time.  

For example, at or around round numbers, (e.g. USDJPY 110) just above or just below a moving average or indeed close by the same support or resistance levels everyone else is keenly watching.  

The market is aware of this behaviour and is often on the lookout for these clusters of stop losses. When they are, it's known as a stop hunt.  

But what exactly does that mean? 

Well, a big bank (a price "Maker") might see on their books that they have a cluster of orders around 1.10 on EURUSD, and then be willing to commit large sums of capital to "hunting down" that stop loss level. They do this by moving the underlying price towards it, in a selfish way, to reward themselves, rather than because of natural order flow (and they wonder why they have bad reputations!).  

As an aside, a broker such as Fusion Markets, that typically services "retail" clients, e.g. mum and dad investors, often get accused of doing the same thing, despite the fact we are a price "Taker" not a price "Maker", and have no control over the prices coming through to you, as a client.  

Think about it if the market can find these groups of stop losses and trigger them, then that's easy money for the banks and traders who have the opposing view and positions.  

Remember that in FX trading there is a winner for every loser and vice versa. A successful trader endeavour's to be on the winning side of that relationship more often than not.

A different approach to stop losses

Are we saying then that you should trade without a stop loss? No, we are not! 

But what if we took a different approach to stop loss placement? Instead of lining up to provide a free lunch for the banks, what if we placed our stop losses above our entry price rather than below it?   

Of course, that means that we'd have to risk-manage our trades in a different way.

For example, employing less leverage and taking smaller positions relative to our account size. But that is really what we should be doing anyway. And of course, we would have to monitor performance closely in a trade's early stages, as we should.  

However, if the trade we have taken is the correct one, then our position will soon be on-side, and once we have a buffer between the current price and our entry-level. Then, our stop loss can be locking in profits rather than minimising (or realisation of) our losses.  

Trailing a stop-loss behind a profitable position is something of a holy grail in trading it's often talked about, but rarely seen in the markets. By not acting like the crowd, maybe we can turn the tables on the stop hunters.  

What are you waiting for? Why not stop your losses in the way they're supposed to be stopped?