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The 4x1 Forex Trading Strategy in a Nutshell

InvestorEducation / Learn to Trade Jan 11, 2011 - 03:06 AM GMT

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Victor Chan Wai-To writes: It is better to teach a man to fish, than to give him a fish everyday. It is better to teach you one principle that you can understand, than to show you a hundred techniques that you don't know how to apply. Therefore, a great instructional writing does not just lay out the methods, but also an intelligence framework with which you can make the methods you own. In my opinion, the bestseller forex e-book, Bird Watching in Lion Country - Forex Trading Explained, is exactly that kind of material that will help you to be a better trader. Unfortunately, the book is pretty thick so it requires quite some time to digest. Fortunately, here is an alternative: I have summarised the core ideas of the book in one article, and it won't take you ten minutes to capture the very principle to trade currencies successfully.

Background of the Book

Bird Watching in Lion Country, or hereafter B.W.I.L.C., is the crystalization of the trading experience of Mr. Dirk du Toit, the author of the book. Ironically, Mr. du Toit did not begin as a currency trader, as it was not yet available when he started. He started out trading stocks, and later he switched from stocks to bonds, beacuse he was more hooked by the macroeconomics that drives bonds, and the fact that he could go short as well as long. He then met a successful bond fund manager who became his mentor. Under the wings of his mentor, he slowly matured into a competent trader.

During the Argentine financial crisis, Mr. du Toit came across currency trading on the internet. After some research, he liked the idea and became a currency trader since then. He found his approach in bond trading to be equally profitable in currencies. At the same time, he discovered many bogus marketers on the internet who sell junk courses and robots of forex trading. Deciding to rectify the trend, he started his own mentoring program in currency trading, and released the first edition of B.W.I.L.C., which soon became a bestseller e-book on the internet.

Core Ideas of Bird Watching in Lion Country

Here are the five core concepts of B.W.I.L.C., which are the cornerstones of sucessful forex trading.

1. Randomness: short-term price is unpredictable. Everyday there are many international transactions going on in the currency market. For example, when an American firm have to pay a German supplier, they have to exchange the dollar for the euro. These events occur all the time and drive the intraday price randomly. Therefore, for most of the time, the day-to-day fluctuation is simply random of which most are just noise.

Since this kind of randomness is beyond mathematical predictions, Mr. du Toit believes that predicting precise levels of entry and exit is like catching smoke. As he said, "close enough is good enough." For the same reason, he believes that there is no trading system that you can blindly follow without discretion. Ed Seykota, a pioneer of system trading, said, "systems trading is ultimately discretionary. The manager still has to decide how much risk to accept, which markets to play, and how aggressively to increase the trading base as a function of equity change. These decisions are quite important, often more important than trade timing." (Emphasis added.)

Mr. du Toit therefore exercises discretion, instead of rigid mechanisms, to time his trades. He trades with a innovative strategy which he called the "4x1 strategy". The strategy includes four "one's":

1. One currency,
2. One direction,
   
3. One lot, and
   
4. One percent.
   

And they are explained below.

2. One currency: be an "insider" of the market.

Traders have two kinds of approaches to the market. The first kind of traders are system-specific, who use one trading system to trade different markets. The second kind are market-specific, who focus only on a few markets but do not restricted themselves to any system. Trend following legend Richard Dennis belongs to the first kind, who uses the same trend following systems for everything from beans to bonds. Mr. du Toit belongs to the second kind, who only trades a few major pairs of currencies. Most other traders are somewhere in between.

"One currency", the first "one" of the 4x1 strategy, simply means you should focus on just one or a few currencies. Why should you do that? Mr. du Toit explained with the following story taken from the book Reminiscence of a Stock Operator. A shareholder visited the president of the company he invested in, and found that the president was extravagant. Convinced that this president meant future troubles for the company, he decidedly sold all his shares. A few months later, the company was in the hands of a receiver. Mr. du Toit said, if you are a shareholder, you may visit the president to obtain "insider information", but where could you find Mr. Forex C.E.O. in the currency market?

The only way to know more about the currencies you trade is to follow them closely, which Mr. du Toit analogised as watching each episodes of the forex soup opera everyday. However, since it takes a lot of time and energy, it is more practical to just follow a few markets you are interested in. As Warren Buffett, the greatest investor ever, said, "if you have a harem of 40 women, you never get to know any of them very well." If you can understand well the markets you trade, you can avoid the risk of doing what you don't know, which is a surefire way of losing money.

3. One direction: take note of the long-term trend.

Markets are moved by large participants like institutional investors. Since they are too large to get in and out everyday, they usually operate for the long-term trend. As Warren Buffett said, "I buy on the assumption that they could close the market the next day and not reopen it for five years." This kind of trend was termed the primary trend by Robert Rhea, author of the Dow Theory. As he wrote: "Manipulation is possible in the day to day movement of the averages. and secondary reactions are subject to such an influence to a more limited degree, but the primary trend can never be manipulated."

"One direction", the second "one" of the 4x1 strategy, means you should figured out current bias of the market, which could be described in direction (up or down) and magnitude (how strong the trend is), and don't trade against it. In order to figure out the current bias of the market, Mr. du Toit believes that one must study the market and sort out the fundamental drivers behind the trend. As Wall Street veteran Victor Sperandeo puts it:

"The primary task of the speculator is to identify the major active factors which drive or will change the predominant trend of market participants' opinions [... which] can include everything from political and economic developments, to technological innovations, to fashion trends, to the earnings prospects of a particular company. Since this can only be done in the context of history, the best you can do is identify the predominant factors of the past and project them on to the future. Some factors remain constant throughout history; and in general, the fundamentals which guide opinion change slowly over time. With effort, you can abstract those fundamentals and forecast the future with a high probability of accuracy." (Emphasis added.)

As the trading adage goes, think like a fundamentalist and trade like a technician. In a similar fashion, Mr. du Toit recommended a trader to "think big, trade small." In all, you should keep an eye on the larger picture of the market.

4. One lot: not losing is half the battle won.

All successful traders practice money management, As trend follower Bruce Kovner said, "whatever you think your position ought to be, cut it at least in half." Famous trader Larry Williams also described money management as the "keys to the kingdom of speculative wealth". Similary, Mr. du Toit pointed out that a large chunk of trading success has nothing to do with psychology or systems. It is simply about using your capital wisely. At the same time, there is no easier way to lose than over-leveraging.

"One lot", the third "one" of the 4x1 strategy, means you should always keep your position sizes affordable. To avoid betting too much in one entry, Mr. du Toit employs a multiple entry system. For example, if he decides that the maximum he wants to bet is $300,000, he would spread it out in three entries of $100,000 at different levels, so that he does not have to pinpoint the best entry in one shot. In essence, it could be summarised as diversifying your entries and bet small in each of them.

When shall you start to average in your position? For example, if you are bullish on the euro, and the price is approach a resistance level which you believe will hold, then you may consider to start entering bit by bit. The advantage of this approach is, if euro rebounds before hitting the resistance, you will not end up missing the move, even though you are not fully loaded with your desired position size. Apart from support and resistance, you can also use it with other technical tools like trend lines, moving averages, fibonacci retracements, etc.

The multiple entry system allows you to do contra-trend trading with a reasonable margin of error. In the words of famous fund manager Paul Tudor Jones, it allows you to pursue your long-term view from a "very low-risk standpoint" until proved repeatedly wrong or you change your mind. It should be warned that, however, that losers average losers. When you start to see the trade to go wrong, entering more to hope for a turn-around is not a solution. You shall cut your exposure or simply exit altogether.

5. One Percent: leave a little for the other guy.

There are two schools of profit-taking. The first school of traders aim to capture the whole trend and take profit only after the trend has exhausted. Almost all trend followers belong to this school. The other school is more conservative, they will take profit if it is good enough. Paul Tudor Jones is a representative of this school, who said he does not mind to have "missed a lot of meat in the middle" as long as he does make money.

"One percent", the last "one" of the 4x1 strategy, means to take profit when it is in-the-money enough. It is therefore obvious that Mr. du Toit belongs to the second school of profit-taking. However, Mr. du Toit does acknowledge the diversification of profit-taking strategies. Although he usually prefers quick profits, sometimes he does hold on a bit longer. Since how far the price will go is unknown beforehand, you cannot never pick the turning point to exit. Mr. du Toit said, "leave a little sunshine for the other guy, we all have to eat." He also said, "one profit a day keeps the bailiff away." The name of the game is making money, not worrying about the "missed meat in the middle".

Mr. du Toit also criticises the so-called risk-reward ratio, which is defined as the captial risked over the expected gain. The games in the casino have poor risk-reward ratios, because little are their wins and huge are their losses in each play. Still, this does not prevent the casino to become rich, because the probability of winning is so much larger than that of losing, so that the overall expectancy of winning (winning amount each time x winning probability) is still larger. Moreover, they are able to keep the crowd go on playing, hence increasing the number of trials and swinging the odds into their favour. Therefore, given large winning probabiltiy and ongoing attempts with adequate sizes, even a poor risk-reward ratio can make you rich.

Summary: The 4x1 Strategy in a Nutshell

Good teachers make things easy to remember. The beauty of the 4x1 strategy is not just about its precision in capturing the essence of currency trading, but also its catchy presentation which makes it hard to forget. Here is the 4x1 strategy in summary:

1. We focus only on "One Currency" and try our best to understand it well.
2. We search for the active driving forces behind the "One Currency" to figure out the "One Direction".
3. We pursue the "One Direction" at a very low-risk standpoint with "One Lot".
4. We practice a conservative but diversified profit-taking strategy with "One Percent".
   

I have thoroughly studied Mr. du Toit's book and come under his private tutorship of trading for over a year. All I can say is his ideas are very good and you can learn a lot from him. I strongly recommend you to read his book and even join his class, especially if you also find his ideas of trading currencies useful.

Victor Chan Wai-To

http://wisdomisprofit.blogspot.com/

Victor Chan Wai-To is a currency trader based in Hong Kong.

© 2011 Copyright  Victor Chan Wai-To - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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