Mentoring - a luxury or necessity
In this article, we will define mentoring and identify how it may be of assistance by examining some of the dilemmas faced by traders. We will then look at one of the most important yet neglected aspects of trading, risk and money management and how a mentor can help by being a 'virtual' risk manager. We will conclude by discussing what one should look for in a mentor.
The concept of mentoring in forex trading is not new. Indeed, in banks around the world, the role of the chief dealer has traditionally been one of mentoring, especially the junior traders. The chief dealer is typically the person in charge of trading. He takes his own positions and gives guidance on how much exposure and sometimes the general direction of the positions. In previous times, when bank trading rooms had many traders handling many currencies, the junior traders would align their positions to those of the chief dealer. This was fairly inefficient, but you were sure to be safe if you were the same way as the boss.
Some chief dealers were very hard on their juniors and used some quite un-scientific approaches: I remember a fiery Irish chief dealer who introduced a new trainee to the dealing room. "You're trading cable", he told the poor clueless trainee. He went out to a meeting leaving the trainee sweating and nervous and when he came back, enquired as to what the trainee's position was. "I haven't got one' was the meek reply. With that, the chief dealer picked up the phone to the broker, sold £5 million in the cable and said, "you have now!"
A mentor is defined as a 'wise and trusted guide or teacher'. He should show the trader the right way of approaching the market and by offering the benefit of his experience, give the trader as much understanding of the market as possible.
A mentor is the person who is going to impart his or her knowledge and experience to you, so that you can learn how to trade intelligently and produce consistent profits. He will show you how to create a plan and implement that plan. He will help you select a broker. He will help you choose a trading system and define the trading rules. He will explain the characteristics of forex trading and the different currency pairs, especially useful if you have come from other markets. He will look at your trading to advise and coach you to improve your performance. He will answer your questions on all aspects of forex trading.
Most importantly, you will improve your trading performance!
The Dilemma Facing Traders:
One of my esteemed colleagues, in a recent Q & A, asked traders to be "hard on themselves" and "be their own supervisor". By definition, this is extremely hard to achieve. Trading has been described as the last frontier of free expression; you are completely free to enter the market and exit the market at will. At the same time, you must have iron discipline to control your risk. You are at once investor and trader and as an investor you must make demands on the traders. Most people do not have this ability to segregate duties inside their head. Indeed, some banks have difficulties implementing controls in their dealing rooms - witness the scandal in a large Australian bank recently, among others.
I believe that it is necessary to have someone to supervise you, because if statistics on trader losses are to be believed, the large majority of traders cannot supervise themselves.
If you decide to go your own way, you must follow some rules. Each trader has a notion of money management I am sure. How much do you commit to a trade? Where do you set your stops? Where do you take your profit? It looks ever so easy in theory, but unfortunately in many cases emotions confuse the issue. The aim is simply to maximise profits while protecting capital against undue loss. Every trade has to be considered as to whether it meets the criteria for entry and upon entry, the level of exit if the criteria is not sustained, i.e. the stop level. The amount of permissible risk is the value of the difference between the entry price and the stop. It should be clear that the capital allocated to the trade divided by the permissible risk dictates the amount traded, thus the level of leverage.
From the outset, it must be decided which trade offers the best opportunity. This involves looking at different currency pairs and bearing in mind the liquidity of each. Why? Because a heavily traded currency pair such as EUR/USD usually offers the smoothest market, whereas GBP/USD can 'spike' (unexpected jumps in the price) which can get you stopped out. You must not get caught in a position that chases its tail, such as being long EUR/USD, short EUR/GBP and short GBP/USD.
In my opinion, you are usually best off in the majors, because they offer the best liquidity and spreads.
How much to risk? Risking all your capital on one trade is ill advised! On the other hand, risking a very small amount of your capital rather limits your earning capacity. OK, you won't go bankrupt. You have to decide on a 'middle way', the way that suits your aggressiveness and one that can be adhered to. More on that later.
Why do we trade? To take advantage of the swings in the market. The idea is to control this so that we take advantage of the profits while controlling the losses. Therefore, one must have a pretty good idea of the level of the potential reward compared to the potential loss before entering into a trade. That is why we use a system with trading rules. The risk/reward (the potential profit divided by the permissible risk) should be at least 1.5:1 if not higher, in the 2.5:1 range. It will be difficult to have a sustainable ratio higher than this. When I say sustainable, I mean one that will give you consistent profits. Therefore, a strategy of taking 16 pips profit against a 12 pips loss is not very clever (even without spreads being taken into consideration).
Successful trading, therefore, would mean that you don't necessarily need to have more winners than losers, but larger winners than losers. It is a question of keeping the losses small. But here is another dilemma: If you set stops too close to the entry level, you will probably be 'stopped out' before the move in your favour. This is especially a problem on longer term trading (anything overnight and longer), because you will have to allow for adverse movements in the thin overlap market between the US close and Asian opening and that you will be looking for larger profits as you are tying up capital for longer periods of time.
While you are in a trade, you will have trade exposure, which is your willingness to assume risk in turn supported by your ability to lose. The ability to lose is how much risk capital you apply and that varies from person to person. That is why I am sometimes amused by claims of systems that show 200% profits in x time frame. What about the risk? Is their risk appetite the same as your risk appetite? Do they mention that they risk 100% of the capital to get 200% return. Possible but risky! So here is another dilemma: how much of your capital are you willing to risk? If you don't address this dilemma, one of two things will happen: you will not lose or gain much OR you will face economic ruin! (Oh yes, there is a remote chance you will make a fortune and then tell everyone that you have cracked it!)
So your aim is not to lose, but should there be a small loss, you are willing to accept it. If you suffer big losses, it will be the more difficult to recover to profit. For example, if you lose 10% of your capital, you have to make 11% to make up the loss and get profitable. If you lose 20%, you have to make 25% profit and if you lose 50%, you have to make 100% profit to make up for the loss!
The amount of capital you are willing to apply to trading activities and your attitude to risk are unique to you and if you don't understand the latter, you will either under perform with low risk, or (in the best case) over perform with high risk. These levels are a part of your overall plan and this plan must be adhered to at every moment. There is a tendency among traders to delude themselves as to what constitutes 'permissible' risk in the heat of the battle.
What is worse, is that new traders confuse speculation with gambling. Given what I have stated, it would be unwise to risk 100% of one's capital on one trade. But this is what some people do, by using 100, 200 and even 400:1 leverage. Ok, you have used your credit card to deposit $1,000 with Sleasy Forex and now you can 'control' $400,000. Yi-ha! You buy £200,000 in cable and immediately, on a 4 point spread, you have 'lost' 8% of your capital. Where do you set your stop? Very close! 50 points adverse movement and you are history! You might as well go to Vegas, in my opinion, because you are virtually 'punting' your capital on a single trade. I am sure that a few of you out there are going to tell me how much you have made with this strategy, but you are defying the laws of probability of the risk of ruin.
The important point here is that although the probability of success and the payoff ratio are a function of the trading system you wish to employ, the proportion of capital exposed is down to how you manage your money. And this is what many traders ignore. In a nutshell, the dilemma is how much capital do I risk?
The next set of dilemmas is based around trader action, or lack of it. Lack of action, or inaction could be defined as the trader missing out on profit opportunities. Perhaps you are waiting for a confirmation of a signal and in the meantime the market takes off in the predicted direction. This could lead to incorrect action, such as jumping in too late, facing the risk of a sharp reversal. Fear of losing can also lead to inaction. At one stage in one's trading life, one is faced with the Mother of All Losses, a loss that washes over like a Tsunami and leaves you feeling devastated. It happened to me in 1984. Luckily, I managed to regain composure very quickly and clawed back 60% of the loss in the same session. However, fear of losses can leave you indecisive. I used to be indecisive, but now I'm not so sure!
The very worst lack of action is where you as a trader will not own up to a lack of judgement; the loss is getting bigger and bigger, but you say to yourself, 'no, I'm right, it will come back', or 'I can't be wrong on this one'. The loss becomes so large that you lose all sense of reality and end up ruined.
I used to know a trader who never admitted his mistakes. His answer was simply 'I got the timing wrong'. He was not mistaken, because timing is crucial. I could give 3 traders the information that the Euro will end up 100 points higher than the current level in 3 hours and only one will get it right. One will buy too early, and possibly get stopped out before the move, the second will wait for confirmation of the move and jump in too late and get 'whipsawed' and stopped out and the third will hit it just right and ride the movement. A fourth, if I had not told him the magnitude of the move, may have gotten out too early.
The dilemma here, then, is entry and exit and although there are many forecasters who will give good entry levels, there are few who will tell you where to take profits - and probably rightly so, because they do not know your risk/reward ratios, after all. But where do you take your profits? There is always the temptation of taking any profit that is on the table, because any profit is better than a loss. It is not optimal. Is there a way of judging when to stay in and when to bail?
In my opinion, there is and it is a combination of having goals set and a certain amount of pragmatism, as long as the trade is going in the right direction. I utilise a technique where parameters of stop levels and risk/reward are a part of the trading rules. On entering a position, the price action is plotted on a chart, with levels for the stop loss and profit target shown. Therefore, by following rules, the trader can judge what is a 'performing' trade or not and act accordingly. If the trade is really performing, clear parameters for taking profit can be developed, avoiding in many cases the phenomena of having had a large unrealised profit end up at break even (see exhibit 1 below)
The Virtual Risk Manager:
I maintain that the real money in forex trading is trading someone else's money. To do this, you have to prove that you are consistently profitable. The degree of profitability is not so important, but the consistency is.
Trading by yourself with limited capital means that you have to take excessive risk to make enough money to live off. You would not believe the number of people who come to me with $5,000 in capital expecting to make $100,000 in the first year! A more efficient way is to build up a track record creating solid consistent results for a couple of years and then get some 'seed' funding. But what are the criteria? Investors have a bumpy ride with forex, because it is not like investing in bonds or equities, where there is dividend/coupon income as well as capital gains (well, there is in forex, but the downside risks are unacceptable to most investors). Last year, for example, the first half was awful for most fund managers, but the big dollar weakness trend in the second half saved many of them. Even so, money poured into the sector (known as the Global Macro sector of Alternative Investments) and it looks like it will flow for a long time to come. Why? Asset Managers have to diversify their portfolios and forex has a low correlation compared to other asset classes.
Investors want to play it safe, though; no huge returns required - just don't make a loss! Drawdown is the key word here and many money managers will not tolerate draw downs of more than a couple percent and even then, it must be for a very short time span. These guys understand risk/reward - its their job!
I know a fund that returned 40%+ last year but only have a couple of million under management. Why not more? Because they have had a 30% drawdown and professional investors run a mile! On the other hand, I know a fund manager who made a modest single digit return last year, and his AUM (assets under management) increased by $25 million.
What does a fund manager do to provide the right numbers? He uses risk management and data analysis. Risk management to ensure that he will get the right numbers and data analysis to convince the investors that he has done the right thing. I won't go through the individual statistics here, but they include Sharpe Ratio, Sortino Ratio, Coefficient of Variance, standard deviation, correlation with indexes, average return, annual return, distribution of returns, etc.
Why is this of interest to you? Even if you are not going to be a fund manager, CTA or the like, you are, as I said, both investor and trader and so you need to be able to analyse your performance especially in the paper trading phase which I will come to.
If you are aiming to be a fund manager, you will have to go through a process which begins with gathering 2 years of authenticated track record, followed by getting some seed capital. Is it worth it? Well, I wondered this as I sat next to my friend in his jet black Ferrari 456 on the way to his country estate - yes is the answer!
How does this all tie in with mentoring? Like this: In a financial institution, the risk management function is segregated from the trading function. Rightly so, we cannot have the two in the same place. The risk manager has to be objective. You, as a trader are under no obligation to have a risk manager, but in my opinion, it is a necessity, not a luxury. You need someone to keep you on the 'straight and narrow' path. Luckily, by gathering trade data, the mentor come risk manager can perform multiple tasks; he can make sure that you are following your own rules and make sure that your data is meeting the standards required.
One of these standards is a benchmark created in the paper-trading phase. Many traders are impatient about going 'live'. When I think of all the 'gofer' jobs I did before I was let loose in the market and STILL needed close supervision, I am shocked that people are prepared to throw their money into trading without the slightest notion of whether they are any good at it! You must find a system and test it - over a prolonged period - to make sure that it performs consistently to your profit/loss ratio, your risk/reward ratio and your risk tolerance levels. If it does, you have to use the numbers generated as a benchmark, because traders have a tendency to do something quite different when they start trading live. I believe this is a 'trigger pulling syndrome' in many cases, because now it is real money and indecision creeps in.
Can all this be done by yourself? Personally I doubt it and that is why I utilise a system that combines monitoring with data analysis. I have come to realise that mentoring by simply saying 'Do as I say' has little value unless I can follow up on the results and guide accordingly. So the system consists of three components, namely a trade entry and monitoring system with a built in profit-taking decision making tool, a journal to monitor a group of trades and finally a journal to look at daily and annual performance.
A word about annual performance. In my many years of trading and observing traders at a high level, I have noticed that monetary amounts bring out the emotions in people. Think of the scenario: You are down $1,000, I mean a thousand bucks! just think what you could have done with 1K! I should have put it in the bank, I mean, a grand in 5 minutes! - been there? Done that? Or - $10,000 in a day- it's obscene- I mean I didn't have to WORK for it- wow! How many have done that and got the T-shirt that said 'I made $10k one day on forex-and gave it back and more the next day'?
Therefore, over the years I have developed a method of looking away from dollar performance and more at annualised return on capital.
This has meant that traders have been able to set a budget target and monitor on a daily basis where they are relative to the target. Because it is annualised, it works on the 'square root of time' principle. That is, if you made 50% annualised ROC after the first month and nothing more for the rest of the year, you would end up with around 17% for the year. It would be prudent to ease off on the risk if you were above your target. For example, if you had a budget of 40% and you were at 50% in the above example, you could afford to go easy or even take a holiday for just over two weeks. Conversely, if you had a risk tolerance of 10% and you overstepped this, you can take a trading holiday until you are under the 10% limit again. The power of the latter method should not be underestimated: It leads to a system of applying a daily 'budget' for the trading day, based on performance to date. A 'must have' for any trader.
Gathering the data does not have to be so precise as for a full-blown fund manager, but risk/reward ratios and coefficients of variance are very important measures of consistency, and this is what you are aiming at. Above all, it is OK to have windfall profits, but large daily draw downs are to be avoided at all costs and this is reflected in the Sortino ratio, the average returns divided by the Downside Deviation (i.e. The standard deviation of the negative returns). You simply must keep your losses small. (see exhibit 3 below)
What you should look for in a Mentor:
Choosing a mentor is largely subjective and being a mentor I am not sure that I can address this without some bias. I hope that I have made a case for a mentor to be a necessity rather than a luxury. Should a mentor be an advisor? I see there are mentors who invite traders to look over their shoulders and see how they trade. Again, this does not address the unique risk appetite and capital of the trader being mentored. And is your golf any better by watching Tiger Woods? Maybe.
The most important factor is the chemistry you have with the mentor. He should endeavour to learn about you and what your aims and goals are. He should respect the fact that you are being mentored so that you will be able to be independent and make consistent profits into the future. Language can be a problem, so ideally you should find a mentor who speaks your native language. Cultural differences also need to be taken into consideration.
I don't think that a mentor should be an investment advisor but there are some who combine this with coaching on techniques quite well.
Should a mentor be an Introducing Broker(IB)? In taking a commission on the turnover for introduced clients, there is the temptation for mentors to encourage high turnover and overtrading - churn and burn tactics.
Of course, the mentor should have forex trading experience - how else can he give the benefit of his experience? Should the mentor be actively trading? Perhaps, but his attention will be half on his own positions and he will have a tendency to 'talk his book'. After all, you are paying for the service, so the mentor should have 100% concentration on your needs.
Should a mentor be available on call 24 hours a day? That is up to the arrangement you have with the mentor, but I would say that this would be an expensive solution.
How is the mentor remunerated? It can be by the hour, by the trade (if the trades are analysed), per e-mail or a combination. Some mentors may also work on a profit sharing basis - no pain, no gain.
Should a mentor have a system? Yes, a mentor should be able to present a system that is known to have a good track record, but again, one man's meat is another man's poison, so it is up to the mentor to find the best system for the trader.
Finally, we come to how to find a mentor. If a trader is making a lot of money in the markets, he may well be satisfied with doing just that. Why complicate things by having to mentor others? Therefore, some ably qualified traders may not want to be mentors. The best recommendations come from word of mouth and there are a few out there (like me) on the net. There are many ex-interbank traders who, like me, have found that they can assist the new generation of traders, using their extensive experience to help traders reach their goals of consistent profits.
The most important point is that you become a better trader with your mentor.
Luxury or necessity -what do you think?