Let’s take a look at several groups who should be expert, and see how they really do. Take hedge funds to start. Over the last decade, their returns (according to Institutional Investor) barely exceed the market returns of 10%. And surprisingly, they’re not even that good! Consider survivorship bias. About 9% of hedge funds go out of business every year- 3 or 4 times the rate of mutual funds. The returns of dead hedge funds don’t get counted in the now too rosy record.

Really lucky and well-run mutual funds in good years (that is, years when the market matches their strategy) might make 15-20%, but the average 5 year return is 9%.

What about “Real Money”? This is the term used to refer to large pension funds, endowments and other expert managers of money. They are very good at diversification, often using 10-12 different markets to extract risk premia, balancing them right in a Markowitz efficiency frontier sense. They have large teams of researchers, and because of their size are able to demand the best terms of trade and narrowest bid-ask spreads. Yet they perform in about the same 10-20% return per year.

What makes a lone, new forex trader expect to beat large teams of experts? The science of behavioral finance tells us that we are subject to a number of rather embarrassing biases. Among them are Overconfidence, Confirmation Bias, Mental Accounting, Illusion of Control and Optimism. If you are not familiar with these concepts, I suggest you do a Google search to understand how our minds work in this space, because these fallacies fan the flames of outsized return expectations, and also lead to demolished accounts.

I am sure someone, somewhere, knows a trader who really did strike it rich, making winning trades 90% of the time with some special strategy. Remember survivorship bias - you aren’t hearing about the 99% of traders who blow themselves up, never to return to the game. And luck plays a part, too. As Nassim Taleb points out, if you did find that special monkey who types out Homer’s Iliad on his well-built typewriter, are you really going to expect he’s producing the Odyssey next?

It is very difficult to find trading strategies that reliably make money, especially big money. This just makes sense. If some incredible trading strategy was able to produce 100% every year, everyone would use it (which would diminish its effectiveness), and Goldman Sachs would probably own it and license it.

If you can generate a forex strategy which returns 10-20%/year regularly, you are doing fantastic, beating the experts and the markets by 2X.

Paul Stafford

4X Trader Tools.com

1. I’m just getting started and am suffering from information overload while I learn to trade forex. Will options trading make this worse? This is where options get a bad name, but for little reason. Becoming better at options trading makes you a better normal forex (spot) trader. Paul and I teach very simple strategies that involve putting together no more than 3 options together at a time (meaning you would buy or sell 3 different options at a time), and only use a few strategies that work in different market environments (ranging OR trending). Learning these strategies is quite easy and gives you a better idea of how volatility and price action work in the forex market.
2. How is options trading different from regular forex (spot) trading? Options are instruments that don’t simply increase in value as the currency pair value goes up or decreases in value when the currency pair goes down. Depending on what type of option it is, the option may have unlimited profit potential and limited loss, no matter how far the currency pair moves against your direction. By combining these options (known as “calls” and “puts” together), you can take advantage of fast moving markets in one direction, or you can profit even when you don’t know which direction price will go! You can’t do this with regular forex trading.
3. How can I use forex options to minimize my risk and maximize my return? Forex options have inherent risk protection when you buy them. For a fixed time, price can move an unlimited amount against you but you won’t lose more than the premium you paid. If price comes back, you still gain a profit, without ever getting stopped out!
4. What’s a good entry/exit method and money management system I can use with forex options? Well, this is a whole can of worms in itself and I’ll cover it in another set of posts. Just because you learn how to trade options doesn’t mean that you’ve found the “silver bullet,” or “holy grail.” Options just allow you to express your view better control your risk, and take advantage of different market environments. Once you’ve correctly assessed price direction and volatility, you can plot out an options position graphically (learn how with the “Trading the Forex Market with Options” ebook) and know exactly how much money you have at risk for wherever the market moves to, and take preemptive actions to save yourself.
5. Can forex options be used for short term trading? Yes, but I don’t see the benefit in short term trading. You are just leveraging higher to capture more money out of smaller moves, are paying more for spreads, and have to deal with short term randomness of price action.
6. What brokers offer forex option trading? More brokers are starting to offer forex options trading as it is becoming more popular. As for retail platforms, the better known ones are SaxoBank, Ikon, and Core Options. You can also trade options on currency futures, and options on the PHLX.
7. What kind of commissions/spreads do I have to pay for options? Are they expensive to trade? Options are a bit less liquid than the normal (”spot”) forex market, so the spreads are slightly higher, but if you are trading medium to longer term it should not matter. I would say that they are not that expensive at all. With typical over-the-counter (OTC) forex options brokers, you won’t pay commissions, but spreads can be from 5-20 pips depending on how exotic your currency pair is.

Paul and my “Trading Forex with Options” ebook will be up for grabs tomorrow and I wanted to prep you for options trades before you learn the material. Paul sent me a copy of his trading planner that he uses for every single one of his trades so he can remain completely objective when putting on his trades and be certain about his decision. Would it be helpful to you to know how to gain this certainty and significantly reduce those feelings of doubt and frustration? Let’s walk through each of the components of the planner that he filled out recently:

Forex Option Trading Plan

Look at the chart

The first thing you should do is bring up a chart of the currency pair of interest and note what it’s been doing and the current price level/range it’s been in. This will give you a context of what’s been going on and will immediately show you the current sentiment. You should be answering, “Is sentiment positive, negative, or neutral right now?”

In this case price has tested lows and failed and is starting to develop a positive sentiment.

Weigh positive and negative factors for sentiment to decide on a direction

Ok when you first look at what’s filled out in the “supporting reasons” box, you may freak. But it’s actually not difficult if you can read. Like Paul said in his interview, he just goes to trusted financial sites like bloomberg.com or ft.com, or even investment bank reports and looks at what economic news is coming out and what the market cares about. You can follow the same strategy and simply list what you find here. After listing all of the reasons why a currency pair should increase in the “supporting reasons” box, you can list all of the opposing reasons in the box below it. If you have more strong reasons in the upper box, then you can put on a trade with the confidence that you are riding on a large fundamental driving force. How to do this is all covered specifically in the ebook, but if even after reading that you are still confused, reading Paul’s weekly briefing or reading certain investment bank analysis reports can help you decide on a direction supported by fundamentals.

In this case headlines indicate that stock market crashes are causing the Yen to benefit against the Dollar, but in the long term evidence is overwhelming that the Yen has to weaken (i.e. USD/JPY strengthen).

Decide what the best structure is for the current market environment

Sometimes price has been in a range and you want to profit from an explosion in one direction, or you may only expect it to increase weakly because sentiment is only weakly positive. Or, you may expect price to remain confined to a range. Each one of these possibilities requires a different options strategy. If this seems like greek to you right now, the book covers the basics of how to choose the right options for the right environment.

In this case, the call option is bought near the entry price to express a long view of the USD/JPY, and another call option is sold with a strike price way up at 100 to reduce the amount of money risked on this trade. For a similar reason, a put option is sold below the entry price and has the backing of strong technical support near the strike price.

Plan your exit and be prepared to deal with negative outcomes from the beginning

It’s amazing how most traders spot what they perceive to be an opportunity in the market and only see the positive outcomes that could occur, and think that risk management is as simple as putting a stop loss on.

But let’s think about it: if you went through all that work performing analysis to find an opportunity to profit, what makes you think that you don’t need to go through the same work to anticipate possible negative outcomes and plan your exit strategy?

VAR stands for “Value at Risk” and basically is a way of measuring the maximum likely movement of price within a given time frame and level of confidence given the volatility implied by the market. This is so we can give price plenty of room to “breathe” without risking too much.

In this case, analysis of past price action and words of experts in the media (regarding the Bank of Japan) seemed to both indicate that Japan would be happy with the USD/JPY around 98 or above, so we would be happy taking profits at 98. Using current volatility, with 95% confidence we can expect a maximum loss of $616.

I realize that this may be a lot of jargon for non options traders, but once you learn it you get used to it and really it’s just a matter of filling out each of these boxes every time you approach the market–Then you can forget about second guessing yourself or worrying about getting stopped out. Again, I didn’t explain every little detail here because  I don’t have room, but I’ll be posting more strategies that you need to trade options profitably in the future. If you want to fast track your success with trading forex options, however you’ll want to get the “Trading Forex with Options” ebook when it comes out tomorrow.

What struck me the most in this forex training video was when Paul revealed his track record. I was quite impressed considering the wild market last year. For some of you that percentage may not be very high, but keep in mind it was done with ZERO LEVERAGE and many investors would kill for that much!

From Module 2: “Combining Price Action and Economic Data to Get into the Mind of the Market”