Navigating the Forex Seas: Risk Management Strategies from a Trading Captain

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I. Why Take Risks?

Risk-taking activities existed in prehistoric times. As early as 3500 BC, the Hindu scriptures recorded a game of dice. Therefore, Peter Bernstein mentioned in his book "Against the Gods" that "the modern concept of risk comes from India, the Arabic number system, which was introduced to the West in the seventh or eighth century." Risk-taking is not only an ancient way of playing and profiting but also the basis of all economic development.

If people are not willing to take risks, there will be no development of any form. Without risk-takers, there will be no business contracts or transactions, and no services to speak of. In other words, if no one is willing to take risks, the entire civilization will inevitably stagnate.

"You can't do anything without doing anything. You have to take a step forward, take some action, bite the bullet, and take risks. A good forex trader must engage in some behaviors that are considered high-risk. We took risks and worked hard to get the Dow Jones contract. We won, and the Chicago Mercantile Exchange lost."

"Of course, we are very happy that the final result is like this. We also took risks on the contract connection with the London International Financial Futures Exchange. Many members opposed this connection, and their views were very narrow, always thinking that contracts started in Chicago and should end in Chicago."

"About our new trading building, I also took risks: a state-of-the-art building worth $182 million, a 60,000-square-foot trading center. The former chairman thought the risk was too great and the controversy was too high, but I believe this is the main reason why we won the Dow Jones contract. On this point, the members gave me a lot of pressure. They thought that the investment was too much and the debt was too heavy. I think trading is the same. You have to take a step forward and take risks."

II. Risk Management in Forex

As long as there are risk-taking behaviors, there is a need for risk management, and there is a need to measure risk. Although risk represents the probability of uncertain and adverse events, insurance represents the benefits of adverse events. Because of insurance, risk can be reduced to a level that we think is acceptable, making us willing to engage in risky behaviors.

In principle, the benefits provided by risk-taking behaviors do not come entirely from the initial risk-taking, but also include the risk management benefits provided by insurance means, so that the risk is not too high to prevent us from engaging in a certain behavior. Product warranties are insurance, observing the condition of used cars is also insurance, and salesmen's verbal promises are also insurance. Without insurance, people are willing to take less risk, making progress and development more difficult.

Next, Pat Arbor explains how top forex traders take and manage risks.

"I think top forex traders must have a preference for stability, but this stability cannot be too high, because trading inevitably involves some degree of risk. A trader must have an ideal psychological structure, the ability to take risks, courage, and psychological stability. I think excellent forex traders have a higher preference for risk than normal people or general forex traders. So the question is how to manage risk and how to cultivate a self-discipline spirit of risk management.

"Traders must be able to manage risk, and I think this also has something to do with self-discipline. A top forex trader once told me, 'The key to winning or losing is not how to establish a trade at first, whether it is buying or shorting'; after establishing a position, assuming other conditions remain unchanged, there are only three possible developments in the forex market: rising, falling or staying the same."

"The key is how you manage after establishing a position. If your judgment is wrong, do you have an exit strategy? What do you do if the market moves in an unfavorable direction? In most cases, forex traders always take the wrong action."

Pat Arbor discusses risk management decisions, which are how to reduce the risk of further development of adverse events and increase the probability of favorable events. He provides some different coping methods.

"Of course, you can't arrange every coping strategy in advance, but as soon as the forex market starts to move in an unfavorable direction, it's best to consider exiting or alternative strategies. You usually don't have much reaction time, and you have to act fast."

"Your judgment was wrong. Only when the forex market reverses, returns to the original entry price, and the position is profitable, can you consider adding, and you must not let the losing position sink deeper."

Pat Arbor manages risk by offsetting, usually using spreads or hedging strategies. Spreads or hedging strategies consist of at least two positions, one side profits, and the other side loses. In other words, this is a risk position that has been insured.

"In most cases, the risk is balanced. I try to engage in spread trading or arbitrage trading. If I buy a certain month of soybeans, I usually short another month of soybeans. I mostly engage in spread trading of soybeans or bonds. If I buy long-term bonds, I short 10-year medium-term bonds. In some cases, I also buy a certain commodity alone, but I still get some balance, such as buying corn/shorting soybeans, or buying soybeans/shorting corn."

"As much as possible, try to compare apples to apples, but when necessary, you can also consider apples to oranges, but never compare apples to elephants, and don't try to hedge positions on two completely unrelated commodities, because their profits and losses cannot offset each other."

"Let me give you an example. I just got in touch with the Australian Wheat Association, which often uses our forex market. Australian wheat is hard red winter wheat, which is of higher quality than the soft red winter wheat traded on the Chicago Board of Trade. Soft red winter wheat is not very good for food (it is high-grade feed), but the forex market depth and liquidity are ideal."

"Although the Australian Wheat Association is engaged in exports, they try to hedge outside of Australia, and they use soft red winter wheat contracts, even though the basis of the two kinds of wheat often differs. Even so, the prices of the two wheats still show the same direction of movement, and the relationship between them is enough to hedge. This situation is probably similar to oranges and lemons."

"When necessary, hedgers can accept any haven, you need a place to shelter from the wind, and you need to manage risk. So, if a ship encounters a storm at sea, it needs to enter the port to shelter from the wind, and any port will do."

"The same is true for large-scale international hedging. Although the products are not the same, they are close enough. Take the bond forex market of the Chicago Board of Trade as an example. Real estate mortgage debt forex traders often use our 10-year contracts, although they want to hedge against the 7-year risk position. They use 10-year contracts, and after some adjustments, they can avoid the 7-year risk of the underlying product."

"At the end of the trading day, if you ask a pure spread forex trader: 'Is the forex market up or down today?' He may have no idea. But if you ask him what the closing price difference between November and July soybeans is, he can tell you exactly: '158-168'. He knows the exact ratio spreads of corn and soybeans or long-term bonds and 10-year medium-term bonds, as well as the spreads of the S&P index to the Nasdaq index or the S&P 100 spot index."

I remember a trade that happened in the 70s when a large grain forex trader placed an order to buy soybeans. That day, due to some bearish news, soybean prices hit the limit. Importantly, the November-January soybean spread dropped from 34 cents higher in November to 17 cents higher.

But at that time, both November and January contracts were still trading, and the November contract price was 34 dollars higher than the January contract. For example, the January contract price was 7 dollars, and the November contract was 7.34 dollars.

"One of the world's largest forex traders placed an order to buy November soybeans. They intended to buy 500,000 bushels of November soybeans, and I sold them 100 lots."

"At that time, I was not very experienced. I entered the forex market at 7 dollars bought 100 lots of January soybeans, shorted November soybeans at 7.34 dollars, and then asked the spread forex trader in the hall, 'What is the quote for January-November?' He answered: 'I'll sell you 17 cents, November is higher than 17 cents'."

"I completed 100 lots of trades with him at 17 cents and made 17,000 dollars like that. The grain forex trader bought 500 lots of contracts, so they wasted 5×17,000 dollars, which is 85,000 dollars. I ran to the counter and told the person who took the order the whole situation. He said: 'They told me to buy November soybeans, so I bought November soybeans.' I told him: 'But you can buy January soybeans and then do a spread trade, and you can save 85,000 dollars.' That's right, they do make mistakes."

"So, spread forex traders have to seize these opportunities, people sometimes make mistakes, and the forex market sometimes gets out of order. In the 70s, the Hunt brothers were active in the silver market, and they started buying a lot of silver on the Chicago Board of Trade and the Chicago Mercantile Exchange, and the prices of the two markets were often out of order."

"If Chicago's silver price was higher than New York's, arbitrage forex traders would enter the forex market and bring the disorder back to normal. This is why the market is an important mechanism for determining prices because it can adjust itself. The forex market may get out of order, but the forex market can correct itself."

"As for the aforementioned silver speculation, the Hunt brothers were ruined by the United States. When the Americans saw the silver price rise to 50 dollars per ounce, they started to move the silverware out of the dining cabinet, and smelting plants were set up all over the United States, and a large amount of silverware was melted into silver bars and delivered to the exchange."

"Sometimes there will be disorder, but the forex market will soon adjust itself, whether it is the trading hall of the Chicago Board of Trade or the over-the-counter speculative trading. Seeing the Hunt brothers squeeze the forex market, silver came out all over the country, and the supply of silver surged. The reason is the same, as long as there is disorder, you have to seize the opportunity."

"Not long ago, I also saw a similar situation with the German bond contract. The Chicago Board of Trade also offers German bond contracts, which are quite successful, with an average daily trading volume of about 8,000 to 9,000 lots. Because Chicago's quote was higher than ATP's by two or three levels, I saw everyone very excited. Arbitrageurs started buying at ATP and shorting at the Chicago Hall. Now, we have many forex markets that offer many ways to balance risk."

"You may engage in spread trading because you are not willing to continue to accept the risk of a pure part. You may be bullish on a forex market, and buy a position, but it doesn't go well. You want to continue to hold the position, but consider establishing some hedging positions to reduce risk. If you establish a pure long position in soybeans, you may short some soybean meal or soybean oil, or even short corn, to offset some risk."

"If the S&P index position is not going well, you can short some bonds. Although you continue to hold the position, you reduce the risk and the profit potential at the same time."

"Of course, you can also simply admit the loss, but if you think your opinion is right, you may adjust the original position to spread trade. So, you may make the whole situation a little more neutral, and reduce some loss risk. I don't think this is a very clever strategy. As I said, the initial loss is often the smallest, and the right thing to do may be to exit directly."

Using spreads or hedging strategies as a means of risk control may not suit everyone, and Pat Arbor discusses this point next.

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