This blog post written a few years ago, is a nice reminder of a lesson learned trading the markets.
It never bothers me to lose money in the futures market if an idea is wrong AND I've followed the principles of trading, that's the nature of the game. In all my trades I never assume a greater than 50% probability of payoff. Rigid loss controls assure that the winners are substantially larger than the losers. What does bother me is when I see a break coming and I don't adequately capitalize. At certain points, very rarely, I see a play that is so obvious and the payoff so large in relation to the limited loss, that the only course of action is to plunge. One such play occurred on May 4th, 2016 in AUD/USD.
On April 27th, we received an Australian inflation number that was well under expectation. As soon as the number came out, I understood that monetary policy would need to accommodate. Over the next 3 trading days the price ran back up to 0.77. The run up was related to the impending decision from the Reserve Bank of Australia regarding monetary policy. The expectation was that the Reserve Bank would hold interest rates at 2%. I felt that it was highly unlikely that they would do so given the underwhelming inflation number, but given the conservative nature of my trading, I put the probability of a rate cut at 20%, the probability of no rate cut AND a hint of future accommodation at 30%, the probability of no rate cut and holding steady at 50%, and the probability of increasing the interest rate at 0%.
With a price run up close to the level where it broke 4 days earlier, I asked myself who would still be long AUD. It seems like with a price run up back to previous level, there was significant short covering from the previous break, and the previous 3 months run up in price probably left the market net long. This is important when understanding the asymmetry of the potential outcomes.
There were 2 outcomes for this play, the price either goes down or it goes up. What would it take for the price to go up? I'm not too sure, but I was under the impression that if the Reserve Bank came out with a decision that was not bearish for the Australian Dollar, it wouldn't move substantially higher because of the bullishness already baked into the price after the previous 3 months run up and the run up back to the level close to where it was before the inflation number came out. If they hinted at easing in the future, I felt the break would be sharp and if they cut rates, it would continue until it reaches a new low (0.68264). To understand the payoffs, I had to anticipate an upside number and probability. In the event of no cut, I anticipated at most it would jump .003 before I'd be able to cover my short, but if they cut it would gap down immediately at least .01 and would end the day down .02 (0.75), remember I also assumed it would keep running to .68, but we'll leave that out of this figuring, to be conservative. If they mentioned easing policy without any immediate action, I anticipated it would also lead to a price decline, and it would decline to at least the level it did when the inflation number came out (0.7533). To be conservative, I'll stick with the 0.7533 number for computing the R multiple on the trade. Upside move = .017 and downside move = .003 for an R multiple of 5.67. I then calculate the implied probability of breaking even on the trade. In this case, if the circumstances were re-created over time, the trade would need to hit the upside only 15% of the time to break even. Even though my feeling was higher than 50% on the trade, I never assume more than 50%, but in either case, it is higher than the break even probability. This shows us that over time this trade should be highly profitable, given my assumed inputs, so I sold short Australian dollar futures.
Let me just state that this was a conservative analysis, given my bias to the 0.68 target being reached in the coming months. My goal then was to realize the initial upside, then to hold until it reached a turning point, expecting a move to at least 0.68.
On May 4th, 12:30 a.m. Eastern time, the Reserve Bank delivered a decision to reduce interest rates to 1.75%. The price broke 0.014, and the trade premise turned into a substantial paper profit. The trade premise could've not worked out, and I would've been just as content, knowing that if I apply this line of thinking over the long term it will pay off. It's when, in the moment, emotional responses take over, that's when I make avoidable mistakes. At down .014 I then pondered the reward to come to me when this approaches 0.68 once again. Greed took over, one of two enemies facing any trader. I gave in. I doubled my position and moved the stop loss down so that I would realize at least a small profit on the trade if the price retraced to the stop loss. The price retraced during the night to barely touch the stop I had set before continuing below 0.75, my price target in the case of a rate cut. It then continued to run, and as of writing this, the price for the front month futures contract sat at 0.7258. Had I not doubled my position and moved the stop loss down, this play would've increased my account by close to 33%, and would've been one of my biggest winners for the year (soybeans being number 1). The profit came when I acted in accordance with the principles of trade, understood general conditions, understood the payoffs, and understood that the trade idea is highly likely to be profitable over time given the payoffs. It was when I REACTED EMOTIONALLY mid trade from a place of greed, adjusted my course of action and deviated from the principles of trade, that the position was cut short.
Whenever I make an error like the one I made above, I incorporate it into a pre-trade document. I might as well learn from my mistakes, as the price for the education was extremely high. The lesson here is that, after large breaks, it's not uncommon for price to retrace before the moves continues. The market did continue to move in the direction of the trade premise after the overnight retrace. I have a list of rules that I follow in my trading and rule number 1 is that I never re-enter a market twice on the same day. So for now, I let this one go, and moved on to the next idea, adding the lesson and new rule to a long list that has unfortunately been accumulating over time as the result of many painful mistakes I've made in the markets.