Be The Casino When You Trade

Have you ever wondered why the casino always seems to come out the winner? The answer has nothing to do with luck; in fact, simple arithmetic explains why over time, the casino must be the one to cash in the chips while the gambler goes home with lighter pockets. And once I show you why this must be, you’ll be on the road to turning yourself into the casino and your broker into the gambler.

The reason why casinos have a built in edge on every game is because they always pay less than the actual probability for an event’s occurrence.  For example, on a pair of six-sided dice numbered 1 to 6, there are 36 possible number combinations or outcomes. A 7 is the easiest number to hit because there are six ways to roll it. The probability of making a 7 on any one roll of the dice is 1 in 6 and the gambler should receive 6 to 1 odds, or $6 for every $1 that’s bet, if he is to receive the correct odds based on the actual probability of this outcome.

Here’s The Casino’s ‘Edge’

In a casino, the game played with a pair of dice is called Craps. Among the many types of bets you can make in this game, gamblers can wager that a 7 will be the next number rolled. By rule, this is a ‘one time’ or ‘one roll’ bet; if a 7 is rolled, the gambler is paid and if it isn’t, the casino is paid. There is no limit regarding how many times this bet can be made, except for the limit related to how much cash one is willing to risk.

When a gambler steps to the craps table and bets that a 7 will be the next number rolled, the casino will only pay $4 for every $1 wagered. See where I’m going with this? The casino is paying our gambler 4 to 1 odds when the probability of the event happening is 1 in 6. Over time, for this particular $1 bet, the casino will collect $6 and pay out only $4 every six times this bet is made. The casino has an automatic profit of $2 built in here because it is paying 4 to 1 odds when the event’s probability is 1 in 6. Another way if looking at this is saying the casino earns 33 cents for every $1 that is wagered on this particular bet, or that they have a 33.33% ‘edge’ in this wager.

Of course, in the short term, things don’t happen this simply because it’s possible to roll three or four (or more) 7’s in a row. What also is possible is that a 7 won’t come out for many more than six rolls of the dice. But no matter what happens in the short term, the odds must work in the casino’s favor over the longer term because the mathematical probability of rolling a 7 on any one roll of the dice is 1 in 6 and the casino will only pay 4 to 1 odds.

Now, I’m not going to explain the odds on every game. But suffice to say that every bet has some amount of edge in the casino’s favor.

Here’s How To Become The Casino When You Trade

With forex trading, there are literally thousands of different permutations regarding what can happen before you either hit your stop or target. But there are only 2 discrete outcomes possible when a trader decides to let a trade play out until:

1.       The Stop is reached before the Target

or

2.       The Target is reached before the Stop

As a matter of fact, in order for what I am about to explain to work, it is essential that you not make any random decisions regarding additional entries and exits once you enter a trade. You must adhere to your trade’s stop and target because when you do this, your trade becomes a binary function where the only possible outcomes are reaching either the stop or target. And once your trade is limited by this condition, the probability of reaching either the stop or target first is equal because there are only two possible outcomes. In the casino’s parlance, the odds of being correct (or incorrect) are ‘even’ or 1 to 1.

Let’s go back to our craps game for a moment. We know the odds of rolling a 7 on any one roll of the dice are 6 to 1, but what would happen if a casino paid you 9 to 1 odds, meaning it paid you $9 for every winning $1 wager? If you made this bet six times, you’d lose five bets and win one, which means you would lose $5 and win $9 for a net gain of $4. And even though in the very short term things are not this simple, over time you must be a winner because you are receiving higher odds than the probability of the event occurring.

Now let’s go back to our binary forex trade where the probability of winning (hitting the target) or losing (reaching the stop) is even, or 1 to 1. What if you could set up a trade where the payoff was 2 to 1 or even 3 to 1? In other words, what would happen if you could set up trades where the amount of pips that were paid to you for reaching the target before the stop were 2 or 3 times as many pips for as you paid when the stop was reached before the target.

Obviously, there is nothing to stop you from setting up trades this way. In other words, this is how you become the casino while your broker becomes the gambler who is destined to lose over the longer term because you are going to be paid $2 or $3 for every $1 you lose on a ‘wager’ with an even, or 1 to 1, probability.

However, before you simply jump into doing this, allow me to explain several important factors:

First, in my years of experience, you cannot simply set up trades with 5 pip stops and 10 or 15 pip targets. Trust me, this absolutely will not work because of the randomness of forex price movement.

Second, because currencies like the euro and pound tend to move in the same direction relative to the dollar, if you decide for example to buy them and sell dollars at the same time you must think of this as two trades, not one trade, unless you reduce your normal amount of lots by half.

There are several other factors which traders must adhere to in order to turn yourself into the casino, and I invite you to learn them while attending one of my trading webinars. Contact newstraderfx@yahoo.com for further information.

Yellin Implies The Fed Won’t Sell Assets For 2 Years After QE II

An article written for Bloomberg by Vivien Lou Chen and Joshua Zumbrun regarding comments made by Fed Vice Chairman Janet Yellin on Sunday should go a long way towards sending the following message: The Fed is not likely to reduce the amount of assets it holds for at least 2 years after QE II is completed.

Appearing Jan. 9 at the Applied Social Science Association’s meeting in Denver, Ms. Yellin also gave her strongest possible backing for Mr. Bernanke’s QE policy, saying “I believe it will be effective at fostering maximum employment and price stability.”

According to the article, Ms. Yellin cited a paper by four San Francisco Federal Reserve Bank economists who used the central banks’ main forecasting model, known as FRB/US, to base their findings. Among their conclusions were the following:

1. Private employment is currently 1.8 million higher than it would have been absent the asset purchases. QE I & II will boost employment an additional 1.2 million by the end of 2012.

2. Inflation is currently a percentage point higher than it would have been otherwise, which means the economy would be very close to, if not actually in, deflation at this time absent the program.

3. The model assumes QE II will be completed in a year, that an elevated level is maintained for 2 years, then “unwound linearly over the following five years.”

Putting this together suggests that Vice Chairman Yellen’s assessment regarding the effectiveness of the Fed’s asset purchase program is based to a degree on the assumption that the elevated level of its balance sheet will remain in place for the amount of time (2 years) modeled in the research paper. Ms Yellin, whose term as Vice Chairman doesn’t expire until Oct. 2014, is likely to be a strong advocate of this policy within the FOMC.

According to Mr. Bernanke’s statement to Congress last Friday, the second round of asset purchases is set to be completed by the end of June. Minutes of the December meeting gave every indication that the full allotment of QE II’s $600 billion worth of Treasuries, along with an estimated $300 billion to be rolled over from maturing MBS into government bonds, will be purchased.

As of the 3rd quarter of 2010, the latest data available, household net worth increased by 9.1% as stocks rallied 10.7% over the period after getting a boost from Mr. Bernanke’s first hints regarding QE II on Aug. 27 at Jackson Hole. The S&P 500 gained 10.2% in the 4th quarter of last year.

A Quick 50 Pips Off The NFP

My trade room made a quick 50 pips trading Friday’s NFP report and here’s how it was done.

1.       Plan For Different Scenarios. This involves understanding what the overall bias in price movement will be if the report is worse, equal, or better than the expected number. In this case, my opinion was that the dollar was likely to gain against the euro under any scenario because if the number was weak, the dollar would gain as stocks declined (the typical “risk off’ move). If the number was equal to or better than expected, the dollar and stocks would rise because the economic fundamentals would be so much positive for the U.S. than for Europe. Be aware that this is not always the case so it can’t be used at all times.

2.       Special Situations. The European debt crisis and Wednesday’s job report from ADP (which came out far above all estimates) presented certain issues that had to be taken into consideration. For example, because there currently is a negative bias against the euro due to sovereign debt issues, traders were likely to be looking for any excuse to sell it.

3.       Use Fibonacci. These retracement levels are extremely useful in finding entries and exits. However, Fibonacci can only be used effectively when you have the correct bias.

4.       Be Patient And Wait For Your Price. I’m sure you’ve heard the old adage “buy low and sell high.” In this case, because I expected to sell the euro against the dollar, my goal here is to “sell high and buy low.” I never chase price movements in an attempt to get in on whatever momentum appears to be present; I always wait to get a “better” price, which is this case meant waiting for the euro to rise against the dollar.

One the EUR/USD 5 minute chart, I’ve place a fib on the first candle after the NFP. My goal is to wait for price to retrace to the 61.8 fib retrace level before selling. The stop is just above the 100 level and the target is near the low of the previous candle because that is where the market has traded to euro to recently, setting up a trade with better than 5 to 1 Reward/Risk ratio. As it happened, the entry occurred on the next candle and the target was hit on the candle after that.

If you would like to attend a free session of my trade room, contact newstraderfx@yahoo.com and I’ll send you an invite.

NFP Could Correct The S&P By 5%

It is often said that in life, timing is everything. If that is true, last Friday’s weaker than expected Non Farm Payrolls report for December probably could not have come at a worse time in the cycle since bullishness is high and sentiment has been positive.

There are numerous sources available to fill you in on the somewhat gory details, so I’ll just quote a comment made in Friday’s New York Times by William Dunkelberg, chief economist for the National Federation of Independent Business,

“We need collective patience,” he said . “You can’t recover quickly from a disaster like we’ve been through.”

Stocks have done well after previous disappointing reports, but I do not believe we’ll see a repeat of this now because the NFP has the potential to make people feel less certain about their recent outlook:

1. The New Year’s optimism. People tend to develop positive feelings around this time, which certainly was reflected in the S&P’s 1.6% gain by Thursday. Friday’s report likey dashed the enthusiasm, at least for a while.

2. Wednesday’s job report from ADP. Despite the fact that few if any were expecting to see a number even close to what was reportred, it still raised hopes and upped many people’s expectation for the government’s statistic.

3. Economists had been upping their GDP expectations for 2011. While I am not implying those forecasts will be incorrect, the optimism created as a result probably took a hit.

A 5% correction corresponds to 2 important Fibonacci levels; It’s a .236 retracement of the increase from the 2010 low in July to last Thursday’s high, which itself is close to the .618 retracement of the entire decline from Oct 2007 to March 2009.

Dollar Outlook For 2011

With the Federal Reserve still committed to adding liquidity by purchasing another $800 billion of Treasuries through June, and an economy which is likely to grow between 3% and 4%, we can still look for the dollar to weaken against currencies like the euro, pound and Australian dollar as stocks continue to improve.

However, one cannot simply employ a buy and hold strategy (buying meaning to buy these currencies against the USD); in order to be successful in this market, you will need to use more of a “buy on the dip” approach.

The reason for this is that 4 main risks to the outlook must be taken into account, namely:

1. Further problems with European sovereign debt issues
2. The potential for state and/or local municipal debt problems
3. Rising commodity prices, specifically oil
4. The Fed’s QE program

My basic thinking is that while each risk poses problems, none is likely to create the sort of massive crisis such as experienced after the collapse of Lehman Bros. in September 2008. And while each can obviously cause a period of risk aversion which, as we have seen repeatedly, tends to strengthen the greenback as stocks fall, the declines which occur are likely to present investors with excellent buying opportunities.

First and foremost, while the Fed is not directly intervening, there is an important reason (aside from boosting exports) why it is very interested in having the dollar decline; the risk of deflation.

As economist and Harvard professor Martin Feldstein pointed out in a recent paper, “policies that prevent currency appreciation can lead to inflation in countries with excess demand while policies that prevent currency depreciation can lead to deflation in countries with current account deficits.”

Since the U.S. has a large CA deficit, and the Fed is now dedicated to fighting the risk of deflation by creating a higher rate of inflation, what this implies is that markets are very likely to move as they have been since March 2009 when large scale Federal Reserve asset purchases were announced-rising when major risks are absent, selling off when they occur, finding a bottom as the crisis abates, and rising from there.

The latest flare-up over Europe was a perfect example of this phenomenon, when stocks peaked on Nov 5 and then declined (as the dollar gained) while problems in Ireland intensified. After finding support for several days, stocks began a sustained rally on Nov 30. Meanwhile, the euro has gained 392 pips against the dollar, the aussie 693 pips and the pound 103 pips since then.

If you are interested in attending one of my free forex trader webinars, contact newstraderfx@yahoo.com for an invite.

Should Housing Prices Fall?

Nouriel Robini and Peter Schiff recently posted articles suggesting that housing prices will fall another 20%.

According to the latest Case Shiller HPI report:

The S&P/Case-ShillerHome Price Indices for October showed a deceleration in the annual growth rates in 18 of the 20 MSAs and the 10- and 20-City Composites in October compared to what was reported for September 2010.

The 10-City Composite was up only 0.2% and the 20-City Composite fell 0.8% from their levels in October 2009. Home prices decreased in all 20 MSAs and both Composites in October from their September levels.

In October, only the 10-City Composite and four MSAs – Los Angeles, San Diego, San Francisco and Washington DC – showed year-over-year gains. While the composite housing prices are still above their spring 2009 lows, six markets – Atlanta,Charlotte, Miami, Portland (OR), Seattle and Tampa – hit their lowest levels since home prices started to fall in 2006 and 2007, meaning that average home prices in those markets have fallen beyond the recent lows seen in most other markets in the spring of 2009.

The HPI is reported in nominal terms which doesn’t take inflation into account. But as the chart below shows, home prices when adjusted for CPI are still well above the historical range, suggesting that real prices still need to decline.

What also is interesting about this chart is that it shows how steady real housing prices were for over 50 years. Except to two periods in the early 1980′s and 1990′s (which quickly adjusted back) from 1945 until about 2000 the rise in nominal prices was almost entirely due to inflation.

Where Did The Fed’s $700 Billion Go?

Quick Question:

The Fed purchased $1.7 trillion of MBS, agency debt and treasuries in QE1, which began March 2009 and as of Dec.15 was holding $2.129 trillion on the asset side of its balance sheet.

Commercial banks are currently holding $1.053 trillion on deposit at the Federal Reserve Banks, as noted on the liability side.

So the question is, where did the other $700 billion go? The stock market? Commodity speculation? Capital markets?

Care to guess?

Insights On Trading

As I look back on my trading experiences, one thing always seems to hold true:

When I get the feeling that I have to “rush” into a trade because I feel so positive, it frequently ends up being a loser. What also happens is that even with the ones that ultimately turn out profitable, I very often have to sit with a sizable loss at first. On the other hand, when getting into a trade basically scares the hell out of me (because I’m going against the sentiment), those trades frequently turn out well because aside from being profitable, any losses at the beginning are usually small.

Two Examples Of This

Back on August 27, when Bernanke first talked about QE2 at Jackson Hole, the growing sentiment among a number of observers was that a double dip recession was becoming more likely- hardly the time when you would feel like rushing in to get long long on stocks (and short the dollar) and probably the time you would feel most nervous about doing so. Buying when many are talking about a double dip certainly seems like the dumb thing to do on the face of it.

Let’s look at what happened when QE2 was officially announced on Nov 3. Just a few days later, the Chinese, other foreign countries (like Germany, whose finance minister called it “clueless”), many U.S. politicians and even a good number of important economists (like John Taylor), where quite vocal in thier opposition, saying-among other things-that the fed was attempting to debase the dollar. Trades like buying the dollar against the euro, aussie and pound would have seemed like the dumb thing to do and you surely would have felt very nervous about doing so. Yet, the dollar gained quite a bit.

In the second example, you could make a case for saying the official announcement of QE2 was an instance of buying the rumor and selling the fact since it certainly looks that way (“buying the rumor” in this case meaning to buy stocks and go short the dollar).

What these two examples do have in common is that a strong fundamental which ran counter to the prevelent sentiment had come into play. Bernanke’s hinting at additional QE overcame the idea of a double dip (along with acting as a negative on the dollar) and the Nov. 3rd announcement coincided with Irish problems coming to a head.

With that being said, I’m not implying there never comes a time to rush into a trade. For example, if Greece or Ireland were to suddenly announce they are insolvent (which technically, they are) and were seeking to restructure their debts, or if (God forbid ) a war between N. Korea and S. Korea breaks out, I definitely will rush into long dollar trades because an overwhelmingly negative fundamental would exist which would cause the market to become massively risk-averse.

By no means, neither am I implying that it’s always wise to trade against market sentiment. Indeed, there has to be a very strong fundamental reason to do so and in both these instances, there certainly was.

Two Scenarios:

We can only guess about what would have happened starting in late August if Bernanke had not hinted about QE2 at Jackson Hole (or afterwards). But given that corporate profits and economic data improved over the intervening weeks, it’s reasonable to say there could have been a slow grind to the upside in stocks (while the dollar declined) as the fears of another recession faded (just as they have).

How about the scenario where Bernanke does hint at QE2 in August (and afterwards), announces it on Nov 3, but then no Irish crisis comes to a head? We very possibly could have seen some selling of the news, but what I also think would have happened is that the dollar’s rebound would not have been as strong and that currencies like the euro and aussie would be higher by now then where is was on the day QE2 became a reality.

Pressure Mounting On Europe

Spain’s €3 billion bond offering on Thursday will be seen as a crucial litmus test of investor confidence given Moody’s warning of a credit downgrade.

By their reckoning, Spain’s central government must raise around €170 billion in 2011 on top of €30 billion by the country’s regional governments. It added that Spanish banks must refinance about €90 billion of debt next year. Moody’s did say it believed Spain would be able to pay its debts without its own EU bailout.

Still, those amounts add to nearly 30% of Spanish GDP.

Willem Buiter, former MPC member and current chief economist at Citigroup, believes Spain will be insolvent once the problems in its banking sector are recognized. He recommends the European Financial Stability Facility expand to €1.7-2.o trillion to cover potential demands from Ireland, Greece, Portugal, Spain, Italy and Belgium, but Germany remains opposed to adding funds or issuing pan-European bonds.

But that isn’t all; Buiter also believes Ireland is insolvent, Portugal is quietly insolvent, Greece is de facto insolvent.

As regards Ireland:

Accessing external sources of funds will not mark the end of Ireland’s troubles. The reason is that, in our view, the consolidated Irish sovereign and Irish domestic financial system is de facto insolvent. The Irish sovereign cannot from its own resources ‘bail out’ the banks and make its own creditors whole. In addition, a fully-fledged bailout (permanent fiscal transfer) from EA partners or the ECB is most unlikely. Therefore, either the unsecured non-guaranteed creditors of the banks, and/or the creditors of the sovereign may eventually have to accept a restructuring with an NPV haircut, even if it is not a condition for accessing the EFSF or the EFSM at present.

And as for Spain:

once Spain needs assistance, the support of the ECB will be critical (by purchasing Spanish sovereign debt through its Securities Markets Program — SMP — and funding Spanish banks using Spanish sovereign debt or sovereign-guaranteed financial instruments as collateral or by making loans to or purchasing the debt of the EFSF, legally a limited liability company that could even be made an eligible counterparty of the Eurosystem for this purpose).

In the longer term, there may be a need for large-scale restructuring of the debt of the Spanish banking sector and possibly the sovereign. At longer horizons, high debt levels and political instability in Italy and Belgium may yet give rise to fundamentally warranted sovereign debt crises, while self-justifying crises are possible even in the near term, despite roughly balanced structural primary budgets.

Germany’s Finance Minister On The Euro

Sunday’s Wall Street Journal published an interview with German Finance Minister Wolfgang Schäuble in which he vowed to defend Europe’s common currency and described as “total nonsense” media reports regarding the possibility of Germany withdrawing from the euro. Here are some quotes:

• You can be sure the euro will remain stable. All European countries are determined to keep this European currency stable and we have the means to do it.
• There will be no domino effect because we will defend the common currency.
• Unification is the best thing that came out of 20th-century history.
• Without the euro, Germany wouldn’t have emerged from the financial crisis relatively unscathed.

Because a new D-mark would appreciate sharply relative to the rest of the euro-zone, leaving the euro at this time of crisis would severely damage Germany’s economy in two ways. First, the bulk of its exports still comes from within Europe (despite rising demand from emerging markets) and those customers would be priced-out as German goods became more expensive. Second, as Europe’s largest creditor nation, it holds a vast amount of assets (loans) elsewhere in the zone whose value would plummet as the D-mark gained.

Additionally, this second effect could be amplified because Germany would no longer be able to influence the euro area’s monetary policy and therefore could not prevent the ECB from stoking inflation (which it might do in order to decrease the debt burden of countries like Greece and Ireland). In this scenario, the real value of German loans made to euro-zone banks, businesses and governments would plummet.

Schäuble also shot down the idea of expanding the European Financial Stability Facility, saying that only a “a very small portion” is needed at this time. He also theorized that doing so would “fuel speculation that there are so many more potential problem cases.”

However, as the Journal article pointed out:

A rescue of Spain would largely exhaust the EU’s nearly trillion-dollar bailout fund and focus attention on the    sustainability of government debt in countries at the core of the euro-zone economy, especially Italy. At that point, the cost of the bailouts would simply be too high to keep the euro zone together, some economists warn.

So, the question now is whether speculators will give up their battle over the euro, which likely would allow it to appreciate. History does show, however, numerous examples (see Black Wednesday) when they did not.