Becoming a Path-Dependent or Theme-Dependent Forex Trader

Learn the Importance of the Path

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Stepping Off the Proven Path May Be More Dangerous Than Traders Can Handle. artpartner-images

The path-dependent forex traders can out-perform theme-dependent traders. But the two approaches can complement each other. Which strategy do you choose?

Global Macro Themes

Currency trading belongs in the realm of global macro. Global macro is a hedge fund approach to trading that involves analyzing and studying trade and capital flow from one country to another and capitalizing on economic imbalances that can cause a currency to weaken or strengthen.

The surprising European Union referendum that should result in a Brexit is an example among examples of a global macro theme. In 2016, January through October, the British pound fell against 30+ currencies according to Bloomberg.

On the surface, global macro themes are seen as easy to take advantage of because they are slow to develop and often slower to reverse. Therefore, a continuing theme like a rising dollar often seems like a slam-dunk that a trader should continue to feast on. However, the weight of influences in global macro themes continues to shift. Raoul Pal, hedge fund manager and author of global macro investor recently noted in a Real Vision interview that monetary policy could sometimes be a key driver, while other times can be led by growth and other times inflation.

In other words, the importance of themes can shift which can be frustrating. However, if a trader finds the right theme, which will talk about developing here than they can be on to something that is worth writing.

The frustration typically comes from the chasing a week theme or a theme that asserted price then, and that is when path dependency can help immensely.

What Is Path Dependence?

Path-dependent trading can be synonymous with technical analysis. While some fundamental analysts think technical analysis is little more than witchcraft there are very real benefits to seeing the price as the number one indicator of any trade idea.

When clients ask what the best indicator is out there, there typically looking for a golden key that will provide in this profitable trades. As you can imagine, they are pretty disappointed when I say the price is the number one indicator. The reason is simple. If the indicator says overbought, it encourages a trader to sell. But if the price continues higher like we saw in EUR/GBP in 2016, it does a trader little good to keep hoping the second-tier indicators to price will eventually cause a bad trade to turn profitable.

Path dependency takes a humble trader to work its effectiveness. Naturally, many will say that the markets are the ultimate humble maker. While that is true, there often traders that remain bold at their own peril. The path-dependent trader is humble because they know even their best-perceived themes or trading ideas can easily be proven wrong. What makes a path dependent trader unique is recognizing and committing to bailing out on that well-thought-out trade as soon as the path turns against them.

A path-dependent trader typically looks for price levels to validate or invalidate the trade they are considering or currently exposed at the moment. If the market moves against the price invalidation levels regardless of the theme remaining in play, they close out immediately and regroup their thoughts.

Path and Theme Divergence

What will naturally be frustrating for a lot of non-path dependent traders is that themes and price can diverge for very extended periods. From March 2015 to August 2016 the US dollar roughly traded sideways. During this time, many hedge fund managers and institutional investors per the CFTC Commitment Of Traders Report released every Friday continued to test the theme of aggressive US dollar strength.

The traders came up with multiple well-thought-out, very clear arguments as to why the dollar would strengthen over this time frame. However, for one reason or another, the dollar traded roughly flat, showing the invalidated path theme.

Naturally, the theme in the path could eventually converge, which is what happens in the best trades. However, until they do there is often more pain and pleasure in being in such a trade.

One example of a diverging path and theme was the Japanese Yen for the first half of 2016.

On January 29, the Bank of Japan announced negative interest rates for the first time, and follow the European Central Bank, the Swiss National Bank, and Sweden’s Riksbank into negative rate territory. Obviously, a central bank takes the reference rate negative to discourage saving or hoarding of cash and encourage buying to stimulate the economy. The reasoning goes that who would want to save it negative rates where a bank charges you to hold money? However, after the January 29 announcement the Japanese Yen through the summer of 2016 continue to strengthen so that less than 100 Japanese Yen per Dollar was the exchange rate.

The strengthening yen confused traders around the world as the theme seem to argue Yen weakness so that USD/JPY was presumed to move steadily, and some hoped aggressively higher. No such thing happened in the Japanese yen strengthened across the board.

A similar event happened with the European Central Bank calling negative rates only to see the euro remain stubbornly strong relative to the central bank's wishes. A weak currency allows a country a better shot at growing their gross domestic product through net exports and hopefully putting new jobs in those exporting sectors. Additionally, central banks tend to have a monetary policy objective of rising inflation that we currencies can significantly aid.

Path-dependent traders, looking only a price, were indifferent to themes failing to play out in the Japanese yen or other markets like the Euro. As long as the trend continues, path-dependent traders are happy, and when the trend ends the path, dependent traders know the path has dictated it is time for them to exit their trade whether it was successful or not.

The Good and Bad About Theme Dependence

An additional burden to developing good themes is that they are often filled or fueled by egos hoping the theme generated turns out correct. As noted earlier, path-dependence takes the weight of forecasting off the trader’s shoulders so that their only focus has to be risk management so they can continue following paths in play that work with their trading rules. Many theme-dependent traders become attached emotionally to their theme playing out because they want to be seen as an effective forecaster of global macro trends.

While some theme dependent traders see the technical analysis for path-dependence as witchcraft, the real trickery about theme-dependence comes from the fact that the themes that cause the big moves typically are only agreed upon months after the fact.

As mentioned earlier, in foreign-exchange markets there are multiple factors, whether it be central banks and their monetary policy effects on the economy, trade and capital flows, geopolitical risk or the rising question of fiscal policy and possible helicopter money. While the market is moving, it is difficult to know what theme is in the driver seat and what themes failed to provide a reason behind the move.

Many traders may think, "I do not care if the theme is wrong as long as I make money." They should understand that is the mindset, and I would argue the correct mindset of the path dependent trader. Typically, they are lucky this time that the wrong theme took the price in the right direction. The problem comes when a trader picks a theme and intended price direction, and they diverge against their exposure, causing them to take a loss.

If the theme still seems credible, they may stay in the trade and continue to add to their losses. This approach is the crux of why path dependence can have a significant advantage or theme dependence or theme dependence should bring on a path dependence aspect. If you have ever read the book "Market Wizards," or listen to hedge fund traders discuss admirable traits of other traders, one common trait is the ability to switch from bullish to bearish in a short period. This is another way of saying they are path-dependent over theme-dependent, and that price is the number one indicator to these women and men who manage billions of dollars.

Complementing the Two Approaches

Having a theme that you believe in can be an asset when path dependence is combined. Bringing path dependence into a theme-centered view allows you not to follow the wrong theme into a large losing trade. However, a path-confirmed profitable theme can encourage you to stay in the right trade longer than you would have if you are simply looking at entering a trade with the fixed risk reward, which is a shorter-term approach to trading Forex.

When the theme you selected cause you to focus on which currencies to bind which currencies to sell and the paths are confirmed you can stay with the trade until the path tells you otherwise.

Tools for Path Dependence

Two of my favorite path dependent tools are The Elliott Wave Analysis approach which is a complete technical and path dependent trading system and Ichimoku Cloud. Elliott wave analysis specifically looks at typical price patterns that develop when a trend is accelerating or advancing as well as typical price patterns that develop when a trend is correcting are pulling back they can offer traders an opportunity to enter in the direction of the trade that aligns with their theme and larger path.

Ichimoku Cloud can be perceived as a more challenging technical trading system, but after you spend the time getting to know how the system works many traders never let it go. The cloud acts as a clear path dependent litmus test while the other lines of Ichimoku provide commentary on the strength of the trend or when there is an entry or exit opportunity.