Residents and visitors to the Gold Coast of Florida know that making their travel plans based upon the current state of the weather is often a mistake. Sun can quickly give way to a torrential downpour, and ominous clouds can disperse in a heartbeat bringing rays back in the Sunshine State. In financial markets, price action can be just as mercurial as the weather in Miami. Uptrends or downtrends in financial markets can end within a matter of moments and dull listless ranges could quickly morph into vicious breakouts.

That is why the common trading adage that “traders should trade only what they see not what they think” is bad advice. Take a look at Figure 1.


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Could you tell from the following chart which way the price will move in USD/CAD? With candles consistently making higher lows, a technically oriented trader could easily conclude that a turn is in place and prices are ready to rally. Surprise! See Figure 2. Prices crash further and long positions get slaughtered as most traders get stopped out. How about now? Could a trader make an intelligent forecast off the chart as it is presented in Figure 2? Most momentum oriented trades would now say sell. Prices have broken support and are likely headed lower. Guess what? Wrong again. See Figure 3. Prices have rallied off the lows staging a breakout. Buy! Buy! Buy!


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The Finale
Alas, let see how this series ends. Take a look at Figure 4. Oops! Just as traders bought the breakout prices reversed and likely stopped them out for a loss once again. Looking at this series of charts, can one honestly argue that trading what you see is a profitable strategy? Clearly not.


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It Pays to Have an Opinion
In order to have a good chance of success, traders need to construct a more comprehensive view of price action. Bias is a critical component of that view. The notion of bias may be surprising to most readers schooled in standard trading techniques. Generally traders are taught that opinions can be lethal and trading books are littered with examples of those who went bankrupt trying to fight the tape. Although on the surface all of those tales of caution may sound convincing, in practice every one of those examples is simply a story of a trader with an opinion but without a stop. The true culprit in most trading failures is not the bias of the trader, but the lack of discipline to abort the trade at a predetermined amount of loss.

In trading, profits are often a function of luck, but losses are always a matter of skill. What distinguishes pros from amateurs is that professional traders always know that they can either choose to exit an unsuccessful trade on their own terms or that choice can be made for them by the market. Especially in FX, a market that employs extraordinarily high leverage that allows any trader to post $1 in order to control $100 worth of currency, the threat of a margin call is never far away. Whenever I encounter a retail FX trader who tells me he never trades with stops, I smile ruefully and simply nod my head, for I know that even if the trader makes 99 successful trades in a row, he will inevitably lose his money after one or two inauspicious trades that move relentlessly against him.

Opinion Gives Resolve
However, turning back to the need for bias, the key question remains — why is it really necessary to have an opinion when we trade? First and foremost, traders need to understand that whether they realize it or not they are in fact rendering an implicit opinion every time they make a trade. After all, even a trader who trades “what he sees” is simply expressing the current opinion of the price action. In fact, financial markets are composed of nothing but opinions. Without diametrically opposite opinions — that is without buyers and sellers — financial markets would not exist.

The need for a bias is far more important than most traders realize because it provides the trader with the resolve to stay in the trade in the face of adverse price movement.  A man without belief is a man without strength and conviction, and psychological strength is critical in the highly competitive world of trading. The markets are designed to constantly trick traders into abandoning profitable ideas. Prices will often retrace after breakouts or breakdowns and many novice traders will quickly discard their positions only to see prices follow the direction of the initial move for hundreds and possibly thousands of additional points. Only the best of the traders can endure this “shake out” process, which helps to explain the success of some of the great FX traders of the past like George Soros.

Remember When…
In the almost mythological story of how Soros “broke” the Bank of England in 1992 by going short the pound and collecting a cool billion in the process, one telling detail stands out. In 1992 Soros and his traders had been trying to short the pound for approximately six months prior to its collapse without much success. The unit did not move much against them, but it did not move much in their favor either. When the position finally started to become profitable, many of the traders in Soros’s hedge fund started to cover their shorts as the trade moved 500 points into the money. Furious, Soros screamed at them that they would all be fired if they took profits at that moment. In the end the currency collapsed more than 5,000 points and Soros was credited with saying, “You can not be enough of a pig when you are right,” meaning that when markets confirm your convictions, you must have as much of the trade on as possible.

Another example of the value of bias comes from his book The Alchemy of Finance. Soros recounts a time when he shorted the real estate trusts (REITs), properly perceiving that the market had reached over saturation and was due for a tumble. As his trade worked, he covered his shorts for a profit. Yet what made this case unique was the fact that a few months later Soros revisited his own research report on the subject, which stated that after a normal bounce, prices were due to collapse further as the contracting cycle would continue. Based upon his own report, Soros reshorted the REITs and enjoyed windfall profits as the sector lost more value due to the skyrocketing interest rates of the time. The REIT example shows the power and the longevity of a proper bias in trading.

Bend with the Wind
Of course, trading successfully with a bias does not mean that the trader must be inflexible. In fact one of Soros’s greatest strengths was his ability to dismiss his thesis when the market refused to validate it. In short, bias allowed him to stay in the trades that were profitable and quickly ditch those that were not.

Having a bias does not mean that the trader is stubborn. For some readers that may sound like a distinction without a difference, but ironic as it may seem, trading with a bias can actually help traders to properly change their mind. Sometimes, the most useful information in the market occurs when price moves against logical expectation. Veteran traders know that when markets ignore meaningful fundamental data and often move contrary to the news, something far more powerful is happening in the marketplace, and traders would be well advised to pay attention. As Mark Fisher in his book The Logical Trader notes, “If the market is moving in one direction and most traders have no clue as to why, then the trend is going to be prolonged.”

Recent Market Action
Here is how this dynamic recently played out in the currency market, and how having a bias — albeit a wrong one — would have actually helped the trader eventually to get on the right side of the trend. During the month of April 2006, the U.S. dollar could not catch a break. The U.S. economy, showed healthy employment gains, huge pick-up in durable goods orders and more than a doubling in the growth rate of its gross domestic product (GDP). Yet despite the good economic news, the dollar kept losing ground to the euro. A trader with a dollar-positive bias would have clearly seen that the market was refusing to accept his analysis despite positive U.S. news flow. In fact not only was the dollar long position not winning, but it was generating a string of continuous losses. An intelligent trader would have then considered the following: If the market can’t validate my bias despite overwhelming evidence in my defense, then perhaps I need to flip my bias. As Figure 5 shows, that would have been a wise choice. Dollar-negative news in the form of dovish testimony from Fed Chairman Ben Bernarke propelled the euro higher by 250 points as it recorded eight-
month highs.


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You Need An Opinion
At its core, trading with a bias does not mean trading with your ego. A successful trader who holds a bias does not mean one who thinks he is always right. Rather, he trades from conviction that his analysis points to a certain direction in the market – a conviction that helps him hold his position despite short-term setbacks to his trade. However, if price action continues to disagree with his analysis, especially in the face of seemingly supportive news flows, a successful trader is flexible enough to re-examine his bias. The famous economist and one of history’s greatest traders John Maynard Keynes once said, “When facts change I change with them, what do you do sir?” This delicate balance between the need for conviction and the need for flexibility is what makes trading such an art. In the end however, one issue is clear — in a market of opinions, a trader without one cannot effectively play the game.