The great weakness in many technical indicators in forex markets is the inability to prevent massive losses from when a market turns in such force that previous reversal points are demolished. The ability to detect the difference in forex trends between a trending market and a ranging market can preserve profits and prevent debilitating losses. If the positions caught in adverse market conditions were highly leveraged, the individual forex trader could be shut down.
This will happen no matter how solid the investment appeared to be in ranging market set up, before the trends overwhelmed the position. “Any good investment sufficiently leveraged, can lead to ruin,” according to Ed Thorp, who is a noted hedge fund manager and blackjack player with a Ph.D. in Mathematics from UCLA. Thorp’s book, “Beat the House,” as the first of its kind published back in 1962 that proved it was possible for bettors to prevail over the casino.
Preparing for a trending market is a critical measure in risk management. As Scott Patterson, author of “The Quants,” a book about the failure of Wall Street asset managers utilizing sophisticated computer programs, “…risk management is about avoiding the mistake of betting so much you can lose it all…the mistake made by nearly every bank and hedge fund that ran into trouble in 2007 and 2008. It can be tricky in financial markets which can exhibit wild, Mandelbrotian swings at a moment’s notice”.
The chart below shows how a trending market can upset a ranging market. Before the election of Prime Minister Shinzo Abe in Japan, the Yen was trading well under 100. But due to the quantitative easing programs he instituted that had the Bank of Japan buying up large amounts of government bonds, the Yen to well over 100 to the US Dollar.
In a recent Wall Street Journal article about this trending market for the Yen by Alex Frangos, ““Top Banks Missed Call Y100 Level Soon,” it was reported that not a single analyst from 15 Wall Street firms expected it to break the 100 barrier for the USD: JPY. About this, Frangos wrote that, “Who among Wall Street’s brightest currency minds predicted four months ago that the yen would get to 100 per dollar so soon? Nobody, that’s who. None of the currency analyst teams among the top 15 currency-trading banks surveyed by Dow Jones Newswires at the end of last year penciled in ¥100 to the dollar by the second quarter.”
Failure to recognize a trending market can be very costly, particularly with leverage deployed. A number of foreign currency shops went under in the first quarter of this year due to trending markets that went against positions. For the individual forex trader, it is even more important to be prepared to determine what is a trending market and what is a ranging market.