Know Your Flow

Those of you who follow me on twitter every day know that I am big proponent of trading flow – that is trading in the direction of the immediate trend which has proven to be profitable strategy in the FX market, especially over the past several months.

Indeed, it is only when I stubbornly fade the market that I get into serious trouble. Last week I wrote about how I burned a whole week’s of gains in two hours of impulsive counter trend trading before finally getting control of myself. This week I am happy to report that I have recovered almost all of my losses by trading only flow based ideas.

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Trading flow successfully, however, requires discretion. You can’t simply follow every breakout and assume that the trade will go your way. Flow works best when it is backed up by strong investor sentiment and supportive fundamental data, so you need to be selective. Although I trade my flow ideas primarily on the EUR/USD, this week I was able to capitalize on the downdraft in the pound when I traded my “meat of the trade” setup on Tuesday in the wake of very weak UK GDP and Current Account data. Conversely I refrained from chasing the downside in the EUR/USD on Thursday, surmising properly that the sell off was just knee jerk profit taking in the wake of the Greek austerity vote.

Flow trades work well when there is strong central theme that captures the market’s imagination and results in a steady continuous unidirectional price flow. On the other hand they can be a nightmare to trade during times of turmoil and chaos. You would think that when investors panic prices tumble in straight line generating flow winners but the reality is that volatility increases markedly during those times and creates a torrent of stop outs. That’s why 2008 consistently comes up as the worst year for flow trades as markets lurched back and forth in great waves of sentiment extremes.

Understanding the limitations of your strategy is crucial to your long term success in this business. In trading, no methodology works all the time and looking for the “magic formula” is an exercise in futility. Much like the alchemists of the middle ages or the explorers in search of El-Dorado, traders who want to win all the time are doomed to failure. It is much better to know the weaknesses of your strategy ahead of time and be mentally prepared for the inevitable drawdowns than to constantly search for something new that will inevitably have its own problems.

For my personality and temperament the flow trade structure works well, but I am under no illusion that this is a path to easy riches. All trading methods require constant work and fine tuning in order to stay ahead of the market. That’s why you need to know your flow before you trade it.

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