The Turbo Turtle

Trend Following for the Foreign Exchange Markets

By

Andras M. Nagy

Smashwords Edition, See License Notes

Murine Communications

Sacramento, California, USA

© 2009 by Murine Communications

http://www.theTurboTurtle.com

License Notes

This ebook is licensed for your personal enjoyment only. This ebook may not be re-sold or given away to other people. If you would like to share this book with another person, please purchase an additional copy for each person you share it with.

If you’re reading this book and did not purchase it, or it was not purchased for your use only, then you should return to Smashwords.com and purchase your own copy. Thank you for respecting the hard work of this author.

Table of Contents

PROLOGUE

There are several books on trend following and Turtle trading but none of them approach this simple yet lucrative trading style with the small trader in mind. The biggest and most successful hedge funds employ the trend following method but nobody has ever tried adopting this system for the average, smalltime trader or investor.

A while ago I purchased the Turtle Trading System from Michael Covel via his web site. It cost me approximately nine hundred dollars and set me on a true path of discovery for the truth behind this elusive methodology. At the time of my purchase the Turtle System was still very much a secret, a secret in regards that all traders who employed this have made a solemn vow of secrecy to Richard Dennis upon their induction to the course.

Naturally, I was curious if Mr. Covel was a “Turtle” himself and chose to disregard this promise of secrecy or, had he learned it second hand?

I was a little disappointed with the material I have received from Mr. Covel in regards of direct application of the system as it was impossible for an average trader. Did I just waste nearly a thousand dollars on some internet scam? Or was this system indeed one of a kind and possibly the answer to struggling traders everywhere?

At the time of purchasing Mr. Covel’s Turtle trading course I was a veteran trader and I must admit I was not a most successful one. I have tried my hand at professional trading on the Chicago Board of Trade and of course on Wall Street.

To my dismay most people, even close associates, steer traders into trading for the short term, darting in and out of the markets, ignoring the longer term moves hence sacrificing bigger profits.

Long-term Currency Trading as an Inflation Hedge

The rule of 72 says that if we have 4% inflation, our currency will be worth half of what it is today in 18 years. Of course inflation sometimes runs faster. In 1975-1985 the dollar was halved in that 10 year period. I think our currency will be halved in the next few years. 20% inflation would mean our currency would be halved in 3.6 years. I am not in custom to predict the future, but knowing these facts could help the reader navigating in the coming perilous financial times.

Currency values are exchange rates between pairs. The same, more or less, as is the inflation in Europe or Asia. The trick is to identify the strongest currency for the long haul and trade it on the long side and short the weaker ones against the strong.

The Demise of the Dollar

The dollar, due to “We The People” and a few politician’s inability to curb government spending, is on a long downward spiral. This move has not manifested itself more as we gauged the US dollar against its main competitor, the Euro or the British Pound Sterling. This is, in part, due to the poor education the average currency trader gets from Forex brokers and self appointed “experts”.

Since these major currencies (along with the issuing courtiers) suffer from the same maladies the greenback suffers, the mutual weakness of these other currencies hide the true weakness of the dollar.

In addition to this fact, the dollar historically enjoys the reserve status. Where in any political and economic uncertainty, the dollar, no matter how weak it may be, gets propped up by investors fleeing their own currencies.

This book hopefully opens eyes and shows real, usable methods for average trader who hopefully can benefit from what I have learned the hard way.

The Turtle method does work¹, and it works well. Here are the caveats with it:

1. The majority of people don’t have the discipline to follow it because only about 5-10% of the trades are really big winning trades; sometimes that is only 1 or 2 trades a year. If you miss these trades, the system will lose you a lot of money.

2. People prefer day trading because it offers more action and thrill.

3. Most novices ignore “position sizing” which is the most important aspect of trading.

The Turtle Experiment

The pivotal personality to the Turtle legend is the oversized figure of Richard J. Dennis, a commodities trader, also known as the “Prince of the Pit.”

Richard was born in Chicago, January, 1949. In the early 70s, he borrowed several thousand dollars and reportedly made $200 million in about ten years.

Dennis earned a bachelor’s degree in philosophy from DePaul University, then accepted a scholarship for graduate study in philosophy at Tulane University, but then changed his mind, and returned to his trading on the floor of the Chicago Board of Trade.

In a stark contrast to the vast majority of floor traders, who quickly “scalped” trades in and out of the market, repeatedly throughout a trading day, Dennis held positions for much longer periods, seeking to profit from riding along with a trend. He traded commodities from the floor like institutional mutual fund managers invest in securities — riding out short term fluctuations and instead of scalping, holding over the intermediate term to capture significant moves. Dennis often pyramided his positions. In time he realized that moving off the floor would enable him to monitor more markets with more comfort, so he opened an office upstairs in the Chicago Board of Trade.

Dennis prospered enormously, and early, in an era in which “anyone with a simple trend-following method and a dart board could make a million dollars,” a period of repeated crop failures, and such consequent events as the “Great Russian Grain Robbery” of 1972, when Russian agents secretly purchased 30% of the U.S. wheat crop in the space of a few weeks, which set the stage for solid, sustained price trends in both directions for the next several years.

Dennis firmly believed that successful trading could be taught. To settle an argument on that very point with William Eckhardt, a friend and fellow trader, Dennis recruited and trained 21 men and 2 women, in two groups, one from December 1983, and the other group from December 1984.

Dennis trained his “Turtles”, as he called them, for only two weeks. He then gave each of them a million dollars of his own money to manage, and proceeded to turn each one loose on the markets. When his experiment ended five years later, his Turtles reportedly had earned an aggregate profit of $175 million. Some of those Turtles began and continued careers as successful commodity trading managers.

Dennis managed pools of capital for others in the markets for a while, but withdrew from such management after his clients suffered heavy losses. In the Black Monday stock market crash of 1987, he reportedly lost $10 million, with a total of $50 million reportedly lost in 1987-88. In 1990 his firm settled investor complaints of his failure to follow his own rules, for over $2.5 million, without admitting any wrongdoing.

Later Dennis published op-ed articles in The New York Times, The Wall Street Journal, and the Chicago Tribune. He is the president of the Dennis Trading Group Inc. and the vice-chairman of C&D Commodities, a former chairman of the advisory board of the Drug Policy Alliance, and a member of the Board of Directors of the Cato Institute.

Eckhardt never finished his PhD in mathematics, claiming that he left graduate school for the trading pits after an unexpected change of thesis advisors. Despite leaving academia prematurely, Eckhardt had published several papers in academic journals.

William Eckhardt later founded Eckhardt Trading Company (“ETC”): an alternative investment management firm, specializing in the trading of global financial futures and commodities, which manages over $1 billion in managed accounts, domestic and offshore products. The firm’s international clientele includes “fund of funds”, corporate, private, and institutional investors.

Rich and Bill trained his Turtles in the Union League Club in downtown Chicago, an unlikely place for the group where the ambiance was in direct conflict with Dennis and his Turtles.²

Top earning former Turtles (now hedge fund managers);

Jerry ParkerChesapeake Capital
Paul RabarRabar Market Research
Liz ChevalEMC Capital
Howard SeidlerSaxon Investment
Tom ShanksHawksbill Capital
Jim DiMariaJPD

Michael Dunn

Salem Abraham

Bob Pardo

Bernard Drury

Mike Shannon

There was/is a minor controversy amongst the vendors and systems sellers who are the most outspoken promoters of the Turtle System. There was a lawsuit involving the use of the now trademarked Turtle Trader name. There was a fight and as I have heard an additional lawsuit between the two Turtle authors, Mr. Covel and Curtis Faith. The core of the controversy was the alleged lack of trading records of Mr. Faith and the fact that Mr. Covel was never a Turtle or a trader for that matter. He is a self described financial journalist/author. This being said, Mr. Covel is a very knowledgeable author who wrote a very readable and detailed book of the subject.

There is also a controversy of the Turtle rules of these two authors such as how many units they traded per market? What constitutes being “loaded”? The rule Curtis states is 4 units, according to Covel is 5 units.

In addition, there are discrepancies in the two books of what were the portfolio management/diversification methods. The original rules state 6 units in closely correlated, 10 in not correlated and 12 long/short overall. And… there is the issue of pyramiding - both Mr. Faith and the original rules state pyramiding every 0.5N - Covel claims it was every 1N to keep the 2% risk.

In his book, the “Complete Turtle Trader”, Mr. Covel alludes to this apparent discrepancy.

“However, as long as the risk Faith was taking was within the parameters, this was not considered a big deal. DiMaria was quick to correct that view: “No, not within the parameters. That was sort of the standing joke. There were parameters and then there were Curtis parameters. He just got to do whatever he wanted. It’s as if the whole thing was decided on the ‘who knows what?’ criteria. Who were going to be the good traders and who weren’t? And returns be damned! It was totally fundamental. It was, ‘Mike Cavallo, he’s like the smartest guy in the program. We got to give him a lot of money.’

I was at the other end of the spectrum. Maybe because I was a control person and they thought I wasn’t going to be anything.” Mike Cavallo, who viewed the allocation process as a meritocracy, did end up having some questions, too. He thought Dennis was partly awarding trading aggressiveness, placing bigger bets with Turtles he thought were trading better, but even Cavallo could not understand Dennis’s decision- making logic when it came to Faith.

He said, “It seemed like Curt was trading too aggressively and too riskily and yet was getting rewarded for it. He was making the most, although probably not on a risk- adjusted basis. So at the time, it was just sort of puzzling. I’m not particularly a jealous person, so I wasn’t too worried about it.” Cavallo knew Dennis had become very successful as a very young man by taking big risks.

The implication was that Faith was Dennis’s chosen one. Others said the C&D brain trust were enamored with the fact that Faith was so young. It became increasingly apparent that the whole subject of allocation issues was just an entry into the central sticky issue of the program: favoritism. The disparity began almost out of the gate. There was a heating oil trade only weeks after the Turtles’ initial training in 1984. The Turtles were supposed to be trading much smaller sizes.

They were supposed to be trading “one lots” or just one futures contract. Faith apparently traded much larger and made more money than all of the other Turtles. Cavallo thought Faith had exceeded what they were allowed to trade, but he also thought an arguably reckless or “go for the jugular” attitude may have elevated him in Dennis’s eyes.

It kept coming across loud and clear from assorted Turtles: Faith’s trading didn’t reflect what they’d been taught. Cavallo, the Harvard MBA, was brutally honest: “It wasn’t at all what we were taught. In fact, you could say it was slightly counter to what we were taught.”

Even though Cavallo was making millions and was easily considered a top- grossing Turtle at the time, the fact that Dennis gave more and more money to Faith perplexed him. Cavallo had no ax to grind in talking about Faith. In fact, years later he served on the board of directors of a firm Faith had started. Why was Cavallo concerned about Faith’s style of trading?

He worried that Faith was risking so much that he could ultimately be ruined (as in mathematical risk of ruin). From that first day of class Eckhardt had pressed home the point of managing risk, but many Turtles saw it almost immediately being ignored by one of their own. DiMaria, who was only eighteen months older than Faith, saw everyone playing by the rules during the program except Faith. He said, “That would go to position sizing, markets traded . . . he was the special boy wonder. So he could do things that the rest of us couldn’t. He probably doesn’t realize that. Did he have special rules ahead of the game, or did he change the game and then ask if those new rules were okay?”

What is the Foreign Exchange

Properly applying what is written in this book could make the reader independent - independent from monetary or employment problems. The US dollar is going through historical metamorphosis from a world’s exchange currency to a minor player in the currency markets. This move may take decades to unfold and properly picking the counter currency to trade the dollar against could be the biggest and most lucrative trade for the coming years.

The problem is most traders, like little robots, are being ‘trained’ by the Forex brokers who are, by any stretch of the word, not their friends³. The novice traders learn Forex trading in completely the wrong way. For example, they learn to trade USD/EUR and when both continents’ currencies suffer economic turmoil the pair will sink in tandem seldom offering nice trends hence lucrative profit potentials.

Why Fundamental Analysis is not practical for most traders?

It is important that the reader learn the macro economic forces that drive the currency markets. However it is not wise to act upon fundamental data alone. Simply put, there is something that is overlooked and there are factors that unknown to the novice.

Listed below are the most important fundamentals that compound the macroeconomic scenario and drive the Forex market:

Monetary policy set by the FED through the participation in open market operations.

• G-7s economies and Asian Economies

• Trade Balance

• Domestic Consumer Price index

• GDP growth

• Money supply growth

• 10 year asset bear yields

• Interest rates

• Money markets

These aggregate gross inputs and their derived indicators combined with the political considerations in each of these countries comprise the framework in evaluating a nation’s currency relative to another. Derived macroeconomic indicators include factors such as GDP growth rates, interest rates, inflation, unemployment, money supply, foreign exchange reserves and productivity. Political considerations impact the level of confidence in a nation’s government as the climate of stability and level of certainty.

In order to effectively trade based on the aforementioned market catalysts, it would require that person to be on the cutting edge of all globally economic, social, and political activity and news. Additionally, it would require one to have a theoretical framework that has the capacity to successful project the evolution of the aggregated indicators. This fundamental trader would be competing with other fundamental institutional traders who have teams of PhD filled research departments with eyes and ears all around the world 24 hours a day, 7 days a week. The average trader therefore must recognize that trading in this fashion, based on the factors listed above, is an extremely difficult task.

However, a trader can be profitable with the limited resources by basing their trading decisions on the sole observation of the data itself, assuming that price has already incorporated all the necessary information into the market price.

What is System Trading?

The basis of system trading (trend following) is a combination of risk and money management rules. What are the guidelines or parameters that drive these rules? There are several and these can range from position sizing algorithms, correlation, and volatility to exit strategies. So any of these various calculations can be applied to create a risk and money strategy, but there is one major rule that is prominent for trend following -measure risk before a trade occurs.

This is why Turbo Turtle Systems use position sizing, correlation, and volatility and exit strategies algorithms to determine risk or loss. Turbo Turtle is a complete mechanical long term trading system that trades the Forex market. Turbo Turtle is based on unique algorithms that monitor risk while capturing major movements in a trend, also during the trend process whether there is a long or short position. Adjustable or systematic stops are implemented to insure that risk is minimized according to volatility.

Trying to encapsulate system trading in a short topic can be a complicated process because of back-testing parameters over data, therefore all trend following or system based trading are driven by algorithms not fundamental or technical in analysis. One last important note: system trading is not based on emotions. Trend followers have found that human emotions can evoke indecisions that can hamper one’s trading ability.

What is The Foreign Exchange Market?

With a daily volume of $1.5 trillion, the Foreign Exchange (Forex or FX) Market is the largest in the world - 30 times larger than the combined volume of all U.S. equity markets. Historically, banks dominated the FX cash markets and offered Interbank dealing spreads (typically 5 pips or less) only to their largest or most valuable institutional clients. In contrast, the dealing spreads typically available to other market participants were much wider (50-100 pips or more in many cases), which essentially excluded their participation in the currency markets.

For this reason, the International Monetary Market began quoting currency futures in an effort to give the retail customer access to this 1.5 trillion dollar a day market.

However, Internet-based FX trading firms now offers retail investors direct access to the cash markets, with 24-hour trading at Interbank spreads.

The following are added benefits when trading the Forex market:

Limited Risk

Traders can NEVER have debit balances trading Forex! In the event that funds in your account fall below margin requirements, the Dealing Desk will simply close all open positions. Simply put, it means that, even if you are dead wrong and there is a catastrophic market move against you, you can never lose more than the amount of money you have in your account. In addition, by using stop loss orders that are guaranteed, your risk can be further limited and defined. That provides you with tremendous peace of mind.

Instantaneous Execution and Firm Prices

The futures market does not offer instant execution or price certainty. Even with electronic trading and limited guarantees of execution speed, the price for fills on market orders is far from certain. In the futures market, the prices represent the LAST trade, not necessarily the price for which the contract will be filled. With Forex, in contrast, you get instantaneous execution and price certainty. As with FX trading, you trade directly off real-time streaming prices and your trades are filled instantly. There is no discrepancy between the displayed price and the execution price. This holds true even during volatile times and fast moving markets.

Maximum Liquidity

Due to its enormous size (46 times bigger than all futures markets combined), the currency market is the most liquid market in the world. The spot currency market is a $1.4 trillion daily market, making it the largest and most liquid market in the world. This market can absorb trading volume and transaction sizes that dwarf the capacity of any other market. If you compare this to the $30 billion per day, futures market, it becomes clear that the futures market provide only limited liquidity. The currency market, in contrast, is very liquid, meaning positions can be liquidated and stop orders executed without slippage.

24 Hour Trading

Unlike most futures exchanges, the currency market is a seamless, 24-hour market. At 5 p.m.Sunday, New York time, trading begins as markets open in Sydney and Singapore. At 7 p.m. the Tokyo market opens, followed by London at 2 a.m., and finally New York at 8 a.m. As a trader, this allows you to react to favorable or unfavorable news by trading immediately. It also gives you the added flexibility of determining your trading day.

By comparison, the currency markets in the United States, such as the Chicago Mercantile Exchange and Philadelphia Exchange, have regulated hours. The CME, for instance, opens at 8:20 a.m. New York time and closes promptly at 2 p.m. Therefore, if important data comes in from England or Japan while the U.S. futures market is closed, the next day’s opening could be a wild ride. (Overnight markets in futures currency contracts exist, but they can be thinly traded, not very liquid and difficult for the average investor to access.)

Automatic Rollovers

Open positions are rolled over automatically every two days. At 5 p.m. ET you are automatically rolled over in all your open positions (swaps the trade forward) to the next settlement date two business days in the future. As is true with futures, there is often a carrying cost associated with rolling over a position. Moreover, currency positions sometimes can actually make you money on the rollover. That is because your profit/cost is determined by the difference in interest rates between the two currencies. Thus, if you are long the currency with the higher interest rate in the pair, you will actually gain on the spot rollover through the premium relationship of that currency relative to the short currency. The amount of the gain is determined by the interest rate differential between the two currencies, and fluctuates day-to-day with the movement of those prices.

For instance, on any given day, the rollover can be $2 per lot for USD/JPY and $15 for GBP/JPY. Rollover fees are shown in dollars, and are usually posted in the “interest column” on the Trading Station every day at 3 p.m. ET. For day traders who never hold a position overnight, there are no carrying costs.

Forex Order Types

After you decided which Forex broker you will deal with it is advisable to download the execution software they provide and use it in a test mode with no money involved.

Generally speaking there are two order types;

• Market order

• Limit order.

A market order is an order to buy or sell at the current market price. Customers using their chosen online currency trading platform click on the buy or sell button after having specified their deal size. The execution of the order is almost instantaneous. Placing a market order by phone is quite similar but usually takes a few seconds more time.

The exact process is as follows:

1. You specify the currency pair and the deal size to the dealer.

2. The dealer gives a two-way price (BID and ASK price).

3. You take one of the two prices (he may ask for a re-quote).

4. The dealer confirms the trade. Under normal market conditions, the Forex dealers usually respond to market orders in about 5 to 10 seconds at most. Assuming the customer deals immediately on the offered prices a phone deal can be made in 10 to 15 seconds on average.

You should be aware that it is a correct market practice for such institutions to quote two-way prices to a customer who wishes to trade. A firm that does not do so is very likely taking advantage of their customers’ ignorance as far trading procedures are concerned.

Limit Orders

A limit order is an order placed to buy or sell at a certain price. The order essentially contains two variables, price and duration. The trader specifies the price at which he wishes to buy/sell a certain currency pair and also specifies the duration that the order should remain active.

• GTC (Good till cancelled): A GTC order remains active in the market until the trader decides to cancel it. The dealer will not cancel the order at any time therefore it is the customer’s responsibility to remember that he possesses the order.

• GFD (Good for the day): A GFD order remains active in the market until the end of the trading day. Since foreign exchange is an ongoing market the end of day must be a set hour.

For most brokers the end of the trading day occurs at exactly 23:00 CET.

Stop orders

A stop order is also an order placed to buy or sell at a certain price. The order contains the same two variables, price and duration. The main difference between a limit order and a stop order is that stop orders are usually used to limit loss potential on a transaction while limit orders are used to enter the market, add to a pre-existing position and profit taking. The same variations are used to specify duration as in limit orders (GTC and GFD). Let’s take the following example:

One usage of a stop order is when a trader is expecting a price breakout to occur and wishes to grasp the opportunity to ‘ride’ the breakout. In this case a trade will place an order to buy or sell ‘on stop’.

OCO

An OCO (order cancels other) order is a mixture of two limit and/or stop orders. The two orders with price and duration variables are placed above and below the current price. When one of the orders is executed the other order is cancelled.

To show how an OCO order works let’s take the following example:

Let’s say you sold 500´000 USD/CHF at 1.2290, looking for a short-term move⁴. However you decide that if USD/CHF moves above 1.2310 you want to bail out your position. You put on a Limit Order to buy500´000 USD/CHF at 1.2260, and a Stop Order to buy 500,000 USD/CHF at 1.2310 with an OCO order. This order will close your position with a 30-pip profit if Limit Order is reached first or with a 20-pip loss if Stop Order is reached first.

How do Foreign Exchange Brokers Work

For quite some time the battle has been raging on; what brokers are better than others?

To answer those points, let’s first define what ECN brokers are.

ECN means Electronic Communications Network. Those type of Forex brokers works in a way to enable their clients, whether they are other traders, banks, business makers, to compete, namely to trade, against each other in a system where those same clients can send and receive bids and offers.

The rules are but simple: those clients are matched according to their needs and they simply get the best offers for their real-time trades.

The ECN broker is only covering a small fee for this market service. This commission is the only revenue an ECN broker will receive. They do not earn money for the bid/offer difference (commonly called ‘spread’ in the Forex market). Thus those brokers do have variable spreads all the time.

So since a while traders noted that ECN were doing better than others.

Are they really the market saviors?

As we know, the market is always changing and who has not heard someone complaining ‘why are my spreads so wide? ‘Or ‘I never got slipped that way, what is happening?’ and so on.

Of course, all Forex market strategies are ever-evolving. Anyone looking at some economic reports from those firms can see where some good profits can be done. Those involved in the retail trading market either joined some data release signal clubs or are getting news services or simply are going, just before a release, for their favorite pair. All those small retail markets do get on the data game. Lots of virtual profits are possible with them.

Before taking it further, let’s talk about the other types of brokers.

The STP Broker

While the STP Forex broker (Straight through Processing) will send all the orders being received from their clients to the liquidity providers. The traders have access to the real market; and can do the trades right away without any dealer intervention.

As such, one can find lots of banks and liquidity working with them so there are more advantages for the customers.

People will refer to STP brokers as if they were ECN brokers: but to be a true ECN broker, one must:

• provide the DOM (Depth of the Market) in a data window

• enable their clients to show their own order size in the system

• permit other clients to get those orders

Of course, the traders are able to see where the liquidity is and to execute trades

Such Forex brokers (STP ones) are paid through the spread. These spreads can be variable or fixed.

Variable spreads are done leaving the spread at zero then letting the market take the best bid/ask from all the banks involved. So the more, the better! All client orders are directly forwarded to the liquidity providers (banks) at the original spread quoted by those providers. Usually a pip, or half a pip or any other amount, are added to the best bid and a pip is subtracted at the best ask of the liquidity provider. The STP broker gets the spreads from the banks on the Interbank market. Note that most banks offer fixed spreads.

The broker will then add his/her own small markups to that spread. This is how they are making money and in no way are they trading against their customers.

Next, let’s talk about a major category in the Forex market: Dealing Desk brokers and Non Dealing Desk ones.

Dealing Desk and Non Dealing Desk

The first kind (DD for Dealing Desk) Forex brokers will put their orders though the DD (Dealing Desk) and will give fixed spreads to their customers.

Such brokers make money via the spreads and by trading against its customers.

They are literally called ‘Market Makers’: as they make the market for the traders, e.g.: a trader wants to sell? The broker will buy from him/her! A trader wants to buy? The same broker will sell to him/her! So they are always on the opposite side of a trade thus creating the market.

The trader will never have access to the real market quotes. That permits the DD Broker to use the quotes to his/her own benefits whenever they are dealing with a client.

To resume, the DD broker will earn his money on the bid/ask difference and also when a customer loses a trade. Fact being, the broker is trading against his/her clients (thus entering in an opposite trade).

The second kind (NDD for No Dealing Desk) Forex brokers do not use any form of dealing desk. They will give access to the Interbank market directly. They work with the liquidity providers (banks mostly) to get the best bid and ask prices.

They can trade during news time with no restrictions given there are no re-quotes neither no order confirmation.

Those brokers (NDD brokers) get their money either by increasing the spread (thus making a commission fee) or by directly charging a commission for trading.

The NDD brokers are either STP Brokers or of an ECN+STP kind.

Figure 1 Dealing Desk versus non-dealing desk brokers

Why trade with a NDD Broker?

There are three main reasons to trade with a NDD Broker:

One - Transparency

The trader will enter the real market and not an artificially created one, like if he/she were dealing with a DD broker.

Two - Better and faster fills

This is the result of having a direct and competitive market bid and offers.

Three - Anonymity

No DD is watching who is coming to the market neither asking for any order to be filled. Rather the client orders are done right away through the system network in a 100% anonymous way.

…and what about the DD Broker?

They are able to follow-up, namely to profile, their clients so no anonymity here.

A good example is when a DD broker will split his clients into smaller groups and auto-trading against them because he/she knows on average the client will lose. What if it is a client having success? They will be given frequent re-quotes, slippage and/or slower execution time mostly when there are fast moving markets to allow the broker to offset his own trading risks. Call it being put on the ‘slow mode’.

The transparency is a give or take mostly because it depends on the company rules.

Please remember, those brokers (DD or NDD) are not against any particular trader. They are to their to make money and increase business. Meaning, they will not just work for their clients in a cooperative way. Lots of Forex brokers with lots of clients will indeed help their clients to become successful but please remember: once a trading order is on the table, it is everytrader for themself.

What is happening then with ECN?

People are then asking: why would ECN type brokers do any better and how?

The right answer is with the liquidity providers and with their relationship with the Interbank system.

The explanation is good for most retail brokers. Take into account that relationship is not easily defined because it does come into various forms.

First, when trading, you do have a counter party to all your transactions: the retail brokers.

When you are trading on the exchanges, you sell and another one buys and, from that, the exchange broker gets commission to help with the deal.

So at MyBrokerFX, when you buy, MyBrokerFX is selling and when you sell, MyBrokerFX is buying. Of course, MyBrokerFX can take your position and handle the whole with their liquidity provider. They will put the whole into a pool, take your position with a given liquidity provider that equals their total position. Or they may just keep it in house knowing you will probably lose no matter what.

As such, there are really only one to two steps between you and the liquidity provider (banks), hedge funds or other brokers handling the opposite end of your position in an ECN type marketplace.

Those one or two steps are where your broker’s problem starts when the market is highly volatile, like during an economic release.

Maybe your broker did promise you some ‘fixed spreads’, ‘guaranteed fills’ and/or ‘zero slippage’? Or maybe he/she has not slipped you or widened his/her spreads yet because just taking it from the liquidity pools is enough and your broker wants you to be happy?

Then again... the world is but changing. You will find lots of MyBrokerFX clients starting to trade the news. Of course, some may be successful! Why? Because the market reactions are very predictable! And those customers have been educated and trained on the whole strategy!

But since things are changing.... MyBrokerFX is losing lots of money! The business model they are used to does not work during economic releases.

Why you may ask? Because of those one to two steps between the customer (you or others) and the whole real market.

As another example, MyBrokerFX is selling to you, and to lots of others customers, Yens (or Euros or …) when no one else in the Forex world is doing it! What is happening then? Nobody is selling those currencies to MyBrokerFX either! They cannot cover it!

What will be MyBrokerFX’ next move? If you are a trader, you already know the answer: MyBrokerFX will widen their spreads, add slippage or simply close during those economic releases.

You as a trader, or someone else, do have an expectation when you are buying or selling. You want things to happen. But when you are ending up in a lesser position than first thought... what should you think then? It did happen to you, right? For some, once, for others a lot of the time. Did your broker try to make quick cash on your behalf? Hey! We all think he/she did! Your friends are thinking the same so what’s the deal then being with such a system!?!

Looking around, you are all getting the same news from that old business model.

You then start looking for something better....

ECN knocking at your door!

Until you hear of something new: ECN.

They promise things done better: ‘No dealing desk’, ‘True Interbank access’, ‘Spreads as low as 1 pip’, ‘STP (Straight Through Processing)’, ‘We will never take positions against you’ any more !

Too good to be true?

You then do a trial with some demo account. The spreads are low and more and more! Then the more you play with it, the more it turns out to be not exactly what you first thought of it!

ECN: what is it really?

All our expectations are tied to a simple fact:

What we know about the marketplace. Being honest, can anyone say they really know what to expect in the real Forex market?

That’s why when trying out ECN brokers; we can expect them to work like they used to in the good old days but with tight spreads and no dealing desk (NDD).

It turns out the first thing you DO notice when trying that ECN demo account: slippage.

How so if there are no dealing desks (NDD)?

The reality is, in an ECN environment, slippage is not exactly what it seems to be. Nobody is slipping you. Fact is the ECN broker is simply giving you what you did ask for.

You asked for some market order to go long on the Yen (or Euro or dollar or ….) and that is exactly what your ECN broker is providing you!

Going back to our simple point above: remember than many of us have no idea what a real marketplace is all about!

Do you really think you can buy the Euro at the price on your screen like you will buy some apples having a price tag at your local store?

How did people ended up thinking like that?

Because MyBrokerFX and all those Forex brokers simply trained us to think that way!

They made everything very easy to understand. They gave us lots of simplicity in complex areas. Of course, giving us lots of simplicity means lots of brokers knowing what the real market is simply made profit on our behalf!

Let me explain it with a short example:

In the real Interbank system, an order is simply a request at the market price. Remember that the market is not static! It is going up and down all the time! Sometimes slow, sometimes very fast!

You may order a Euro at 1.3150 but the slight moment it takes you to push the button, send the order and match a buyer.... the market price is then at 1.3154 !

Were you lucky to get a buyer?

During some economic releases, when the market is really volatile, you might have to wait for the Euro to be at 1.3195 before being able to buy it!

Think again: if the US Federal Reserve is releasing a USD negative statement, do you think people will be fool enough to start selling a Euro?

This is the real market! This is the real world! This is a pure NDD system. No broker here is making the market! Sometimes there is a buyer at the price you want, sometimes there is no one!

You might believe you just ended up as before with your old DD broker? You did not! You just entered the real marketplace and it is given you what you did ask for!

Point being: most of us did not know at first what we did ask from that market!

Then some days later with your new ECN platform, you get your first report.

First, the good news; you do not get the 25, 35 or even 50 pip fixed spread you were getting with MyBrokertFX!

But you do notice the spreads do widen a few pips and they seem to jump around a lot, especially on the British pound. The spreads widen, narrow, even invert and just a few seconds before the release! It seems really scary, no?

Think of it this way: banks are pulling their orders and you will always have those last minute traders taking positions!

This is the real world reality of the Interbank system. It is cold, dangerous and scary. This is the market with buyers, sellers and whatever both of them can bear. No guaranteed stop losses in this world!

You will then notice your broker commission. Remember the bid/ask price you saw on your screen is the price being offered in the ECN system. Unlike MyBrokerFX, your broker profit is not hidden in some difference between your price and the liquidity provider price. So for him/her (the ECN broker) to make some profit, he/she is but charging you some fee or commission.

The commissions do vary from one broker to another. As well, most retail ECN brokers will ask on the average for a commission equivalent to 1 to 2 pips per round turn. All depends on the currency pair.

Remember that when it is time for you to take position, you must expect your ECN broker spreads to be better than MyBrokerFX, so it must show a spread of 1 or 2 pips or less, right ?

Reality is: it is not always the case. You will sometimes get better spreads, sometimes not!

So what’s so good about ECN?

One word - transparency…

Or what seems to be some promises of transparency! You might get attracted by the spreads and simply afraid of dealing with the real marketplace!

You can see and deal with the real market so no one can cheat you, right? Everyone wants a fair deal.

Things can turn out that your old MyBrokerFX broker might not be so bad after all. It might have taken fair spreads and they did not lie or cheat you in any way.

Over the years, lots of people were disgusted by their brokers not to mention that business model does put MyBrokerFX into a distrust position. People all over the Forex market were screaming for transparency!

So is the ECN marketplace really transparent? Not really. The only way would be if everyone involved, including the retail trader, has access to the feeds. Unless you have such a central clearing then you cannot expect to play into a really transparent system.

Should I open an account with an ECN broker right away?

This depends on you. If you find your old DD broker is not obsolete and works well for you, why should you change?

New or small account traders might find lots of advantages to working with DD brokers. Remember some of them do guarantee no negative balances: you will never lose more money than you have in your account. This feature alone might be the safety net lots of us are willing to have before committing ourselves to the Forex market.

Others DD brokers provide leverage of up to 400:1. For some of us, it might be very attractive. It might make those stop loss and no negative balance guarantees very interesting after all.

Think about it: having that 400:1 leverage makes the no-negative balance protection a must!

Finally, your old DD broker does offer those fixed spreads. For those of us trading at unusual times, like for the Asian market, fixed spreads are way better than the Interbank, especially for the pound.

So are ECN brokers really so good after all ?

It all depends on you!

You did read and understand each type of broker’s structure and advantages? Right? Generally speaking, experienced and active Forex traders will be more than happy to work with ECN brokers while a newcomer will find himself/herself at home with a DD broker: both for the simplicity and the safety features.

Conclusion

STP brokers make their money on spreads. Even if not having a physical DD (dealing desk) to check or counter-trade their clients orders, those brokers can provide their own prices (the spread markup) to route the trading orders to their liquidity providers. Of course, to provide their customers some advanced trading services, faster execution time, lower account deposits and an anonymous NDD trading environment, those brokers main interest is your trading profitability so they can earn long on the spreads.

Market maker (DD) brokers make their money on the spreads and, of course, by hedging against their clients. Let’s not forget, if you become too profitable, you might upset your broker! Huge and reputable firms should be able to handle clients like you while smaller ones might ask you to leave.

Finally, the ECN brokers do not make profits on the spread difference, only from their commissions. They are only interested to see you as a winner since winning makes them money (commission) and if you do not, they don’t!

In Appendix A you will find some listing of STP/ECN Forex brokers and STP only brokers.

Risk Management

Trading success is 90-percent risk and money management. Learn that well and practice what you have learned and you will have a chance.

What is Risk? Risk is the chance of not having enough money when you need it, to buy something important. Risk is going against the current, taking the hard way against high odds is also about taking risk.

In a world of constant change, taking risks is considered to be accepting of the flow of change and aligning ourselves with it. It does seem to be a reckless endangerment, but for those who understand reality, risk is considered to be quite actually the safest way to cope with the changing uncertain world.

To take a risk is indeed to plunge into circumstances we cannot absolutely control. But the fact is that the only circumstances in this life that we can absolutely control are so relatively few and so utterly trivial as hardly to be worth the effort. Besides, the absence of absolute control, which is impossible in any case, does not entail the absence of any control, or even significant control.

To be more specific, the sort of risks that put one in a position to control one’s lot in a world of incessant change are the risks that attempt to add something of value to that world. To create value, to focus one’s efforts on increasing the fund of that which is worthwhile, involves a sort of risk. Yet, paradoxically, it provides the greatest control over a changing world and maximizes the chances to achieve a truly meaningful personal satisfaction.

The main difference between an amateur trader and a professional trader is that the latter always tries to understand and control portfolio risks. Before entering into any trade, professional traders first think about how much risk to take and how much risk exposure comes with a particular trade selection. Only then do they allow themselves to think about how much profit they stand to make.

Prudent investors always cut down their position and exposure if they determine that a portfolio carries too much risk. They calculate this all-important estimation by employing Risk Management, that set of methods and procedures taken to estimate, quantify, and control risk for the purpose of achieving optimal investment results.

Risk management is the difference between success and failure in trading. Trading correctly is 90% money and portfolio management, a fact that most people want to avoid or don’t understand.

Capitalism rewards those with the brains, guts and determination to find opportunity where others have overlooked; to press on and succeed where others have fallen short and failed. The right decisions lead to wealth and success; the wrong ones lead to bankruptcy and a redistribution of resources from weak hands to strong as capitalism rolls on.

It has been said that the amount of risk we take in life is in direct proportion to how much we want to achieve. If one wants to live boldly, then he must make bold moves. If the goals are meager and few, they can be reached easily and with less risk of failure, but with greater risk of dissatisfaction once achieved.

Some people are kiodiophobic (risk averse) while others are kiodiotropic (risk seeking). The phobes are hesitant to pull the trigger, keep their bets small and have uneventful performance. The tropes pull on any excuse, bet large and take thrilling roller coaster rides.

There are of course, two kinds of risk, blind risk and calculated risk. Blind risk is the calling card of laziness, the irrational hope, the cold twist of fate. It is the pointless gamble, the emotional decision. The man who embraces blind risk demonstrates all the wisdom and intelligence of a drunk trying to speed through heavy traffic. Calculated risk has proven to have built fortunes, nations and empires. Calculated risk and bold vision often go hand in hand. Using your mind, watching the possibilities, working things out logically, and then moving forward in strength and confidence, managing risk and dealing with it responsibly is what is required in a successful trader.

The trick is to come to terms with one’s own tendencies and find a system that honors their psychological needs and also shows profit.

For gamblers from blackjack to horse racing as well as all traders, making serious money demands they get serious. As a result, they take a completely different approach towards betting from people who enter these endeavors for the action, the excitement and, of course, the dream of winning big.

Nearly every profitable investor keeps continuous and detailed records of their trading decisions, thoughts and observations. Recording in written form forces them to function in a disciplined manner. Details on paper structure the decision making process. Anxiety, greed and fear are replaced with confidence and determination. A constant review of the decision-making process that goes into each trade is not enjoyable. But, the process of self-examination is crucial to successful trading. Keeping a journal of decision-making that records when, where, why and how much to bet on each trade or wager is a good control strategy. The idea is to reach a comfort zone, stay within that zone and to quit whenever tempted to leave it. Keeping records is a part of managing money, and if one is not disciplined in money management, he is going to lose his entire bankroll.

So controlling risk is crucial because losses determine that something is wrong. If a person doesn’t know how to determine when he is wrong, then he is headed for utter financial disaster.

• Developing and maintaining a record-keeping system:

• Develop and maintain a record-keeping system that works for you.

• Critique the performance in writing each day.

• Write down the personality characteristics or take a personality test.

• Write those parts of the personality that make you a successful trader, and those parts you must constantly guard against.

• Write down the trading rules and educate one as much as possible about them.

More risk controlling tips: to become even-tempered about money takes practice, one must detach emotions and ego from what he is doing. Being calm, cool and collected and not getting excited about profits will help you in preventing losses. If one cannot control greed, fear and hope then trading might not be for him.

Performance Benchmark, Beta, Correlation and Return/Risk Ratio

If an investor bought a stock at $100 and sold it six months later at $116, then he would realize a profit of $16. His annualized return would be 32%. No doubt, this is a good investment result. Is this a better or worse investment compared with others? Without systematic analysis, we cannot tell: to properly evaluate investment performance, we need to consider the return, the risks involved, and how the outcome compares with other possible investments. In order to quantify risks and measure risk-adjusted performance, following concepts are applied:

Correlation

If the index moves up, percent of the time the stock also moves up. Please refer to the ‘Portfolio Diversification’ section of this book.

Beta

This serves as the measure of a portfolio’s risk relative to the market; if the index moves 1 percent, then the stock moves Beta percent. In Turtle Trading, the beta of one currency rate is often computed with respect to another currency rate.

Volatility

For trading applications, daily volatility is a very useful measure of risk: percent of the time stock price moves up or down percent in a day. It is important to know the difference between this daily volatility and the annualized volatility, which is used in stock option and derivatives valuation.

Return/Risk Ratio

The Return/Risk Ratio is defined as R/v, the higher the ratio the better the performance. If we plot the return against risk for many different kinds of investments, we get a chart like that presented in Figure below:

Zero-Risk Investment might be likened to a bank account that earns risk-free interest. At the other extreme, some individual stocks are extremely risky, leading to a great variation in the range of potential return or loss. In examining many different kinds of investments over long-term periods (say ten years), a graphic representation would appear like a cloud with a rather clear upper boundary - the so-called “Efficient Market Frontier.” If an investment lies on the efficient frontier, it is considered “optimal” or “advantageous.

Investing/Speculating is a “zero-sum” game. On average, passively buying currency contracts and holding them does not generate returns. A successful trader makes positive returns by trading skillfully and consistently.

Sharp Ratio

The Sharp Ratio is a measure of a portfolio’s excess return relative to the total variability of the portfolio. It is named after William Sharp, Nobel Laureate, and inventor of the capital asset pricing model. Let the annualized return of the portfolio be R, the risk free interest rate r, and the annualized volatility v, then the Sharp Ratio is (R-r)/v. It is equally applicable to equity, fixed-income, commodity traders and fund managers.

VAR (Value At Risk)

Most leading investment and trading houses use VAR as one of their main risk measures in routine risk-management operations. VAR is an absolute risk measure for the portfolio, in units of dollars per day. In a single trading day, there is a 95% probability that the portfolio will not lose more than VAR. For example, if the VAR value is $800, then one can assume that it is 95% certain that the portfolio will not lose more than $800 in one day.

Hedging

Hedging means the specific actions one takes to reduce or “neutralize” risks. Hedging entails three steps: First, analyze the portfolio to identify and quantify risks and their sources. Second, in accord with a risk-management system, add, remove, and adjust holdings so that the risks are reduced or neutralized. Third, execute the trades necessary to implement the new portfolio. Sometimes hedging is as simple as selling part of the riskiest instruments in the portfolio, or adding a less-volatile one to it.

Single Trade Risk Management

Single-trade risk management can be summarized by these fundamental principles:

• Know how much one is willing to lose before he executes trade.

• See if the instrument is sufficiently liquid (active) so that one may buy or sell promptly.

• Determine the cut-loss level before trading.

• Determine the profit target (take-profit-level).

• Buy the contract only at an acceptable price level.

• If the trade starts to win significantly, raise the stop level so that the Winner Will Never Become a Loser.

• Take profit promptly as the trade reaches the profit target.

The risk management process has to start before one begins a trade. Most importantly, one must know beforehand how much one is willing to lose, along with how much one can lose in a planned trade. For example, before doing a trade, one should first consider potential losses, and decide if the stop-loss level is reasonable and acceptable.

Portfolio Risk Management

If one actively manages the risk of each trade in the portfolio, the whole-portfolio risk will be well under control. After all, a portfolio is just the aggregate of all individual single trades. However, it is also important to manage the overall risk at the portfolio level. The following is a list of key points for managing portfolio risk:

Know the overall risk tolerance before building up the portfolio.

• Determine the overall cut-loss level.

• Diversify the investment in different stocks.

• Actively manage the risk of every individual trade.

• Know the overall risk and where the risk comes from.

• Act quickly when you see the risk limits exceeded.

• Close out the entire portfolio if it loses to the overall stop-loss level.

Stay in the game.

This last point, “Stay in the game,” is most important in trading and investing. It refers to cutting losses before they are too big. One can remain active by always recognizing risk limits in a trade, cutting losses and building profits.

Recent studies have shown that people don’t tend to be rational economic actors; their decisions are based in part on their reactions to the facts at hand.

If one could always pick tops and bottoms, money management would not be needed. That is not possible though. Pretend a trading system was 99% accurate. The 1% failure rate could still wipe a trader out if he uses no money management. The 1% failure rate could be a loss that far exceeds the winners that you accumulate with the 99% accuracy ratio.

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