In a previous posting I covered a bit about the origins of Grid Trading. In this posting I want to go over a discretionary method of Grid trading that is described in Dirk Du Toit’s Bird Watching in Lion Country (BWILC) and is called the “4×1 method”.

Dirk also offers a mentoring course and a forum which provides support for his method. There are also some bloggers out there who use his methods, such as Colin on his forexspirit blog. I have traded using Dirk’s methods and completed his mentoring course. It has been more than a year since I finished his mentoring material, so what I may have to say here may be out of date, as I found Dirk’s material to be continuously evolving. In this posting I thought I might outline my experience and understanding of his methods. This posting only scratches the surface of his thinking, so If you want to know more, you should contact Dirk.

Randomness

Dirk is a big fan of Taleb’s “Fooled By Randomness” and this has had a profound effect on his approach to trading. Dirk’s view is that a lot of traders fail because they fail to appreciate how random the markets truly are. They try and trade short time frames, believing they can beat the market, when in reality they are just sucked into gambling in a vortex of randomness. This view, for similar reasons to the grid trader described in the previous posting has pushed him into a trading in a way that does not require you to be able to pick the short term direction of the market. However, unlike purist Grid Traders, who try never to pick the direction of market, Dirk does try and understand the underlying fundamentals of the market that is driving the primary trend using relational analysis, and he does try and construct a view about a range of prices where the market is likely to move in the next few weeks using median grids.

Relational Analysis

Dirk is not a big fan of technical analysis. His view is the markets are far to random for technical analysis to be helpful and he prefers to rely on his own flavour of fundamental analysis called “relational analysis”, which Dirk defines as:

Relational analysis is the skill of listening to what the markets are telling you, and making money from what you hear.

Dirk in his past studied a MA in religious studies, as a result this makes him more interested in “interpreting” the story behind the market rather than simply the price action. Dirk’s approach to relational analysis is to look at the relationship between prices, events and time. Basically it boils down to listening to the daily soap opera of announcements and news, look at how price is responding to it and then think about what that is telling you about how other traders are positioning themselves. For example, does the price react to a rate change announcement? (i.e. is the rate change already priced in or not).

While Dirk provides a range of material on relational analysis, it is something at the end of the day that you cannot get by reading, you have to do it to get it. In the mentoring course he gets you to write a daily briefing about the market which he then reviews. The very act of just writing this gets your mind into the mode of following the soap opera of the market. Once you do this for a while you just “get it”. If you are looking for good introductory material on this topic, I did find that the “Inside the Banks” webinar over at forexmentor.com is a good intro on this topic. It is well worth coughing up the couple of hundred dollars to see how the institutional traders do the equivalent of relational analysis.

Dirk also provides his own daily briefings. Some people like them, but personally I found his daily briefings to be a bit idiosyncratic. My preference is to rely on briefings from institutions for relational analysis.

Median Grids

In terms of technical analysis, the most he actually does do is to construct what he calls a “median grid”, which is effectively his comfort zone for grid trading. The purpose of the median grid is to provide reference points or a context for prices. The centre of the median grid provides an indication of where the price will tend to revert to in the absence of major new information. The edges of the grid identifies places which will be tested, and breakouts may happen if significant new information enters the market.

The grid is typically placed on “round” price levels and is typically around 400 pips wide on a 1 hourly chart. For example, the bottom might be at 1.5600 on the EUR/USD and the top might be at 1.6000. The grid can be wider or smaller, depending on the volatility of the underlying currency pair or how long you are willing to hold positions for during drawdown. For example, if you are willing to hold positions for months, like institutions do, then a grid size could be 800 pips wide or more.

Placing the grid is always based on your relational analysis. For example, if you expect the market to range, then the grid might be keyed off of a 20 day high or 20 day low. If you expect the price to trend, then the top of the grid might be as high as 200 pips above the current price.

A grid is only moved if the price violates the top or the bottom of the grid by a significant amount (50 to a 100 pips at a minimum).

The grid itself is broken up into 4 quadrants, each of about 100 pips in size (on a 400 pip grid). Q1 is at the bottom of the grid and Q4 is the band at the top of the grid. These quadrants are used in managing trades. An example grid is placed below.

The “4×1″ Trading Strategy

At the core of Dirk’s approach to trading is what he calls “4×1 Trading Strategy”, which is about building up an edge in trading using 4 different principles of “One Currency, One Direction, One Lot and One Percent”.

• One Currency refers to the notion of specialisation and is about getting to know how a single currency behaves really well rather than spreading your focus across multiple currencies. By “one currency” Dirk usually means the US Dollar. Given the USD is the key currency for most global trade and is held as a reserve by nearly all central banks around the world, getting to know its behavior really well will give you a good edge in trading. Most of his students start by trading a single pair which has the one currency as a component, such as the EUR/USD, but in time most of his students branch out into other pairs with the USD as a component, such as the GBP/USD or the USD/JPY, etc;
• One Direction refers to trying to understand the direction of the one currency you are focussing your trading on and placing all of your trades in the context of the direction of the primary trend. At first this means simply opening trades in line with your concept of one direction. Over time this expands into using relational analysis to know when to add to existing positions, when not to enter, when to buy into dips, when to hedge, etc;
• One Lot refers to position sizing. Initially this is quite literal – only open a single mini lot when trading. In time this expands in to calculating proper position sizing and selecting what you own personal lot size is for your circumstances. Dirk recommends that your maximum position sizing should be about 4:1 leverage. Meaning that if you have a 10K account, you should not have more than 4 mini lots open at any one time. This means that you will probably be still trading with a single lot per trade and as a maximum you will have 4 open positions.
• One Percent refers to when to take profit. It is about taking a profit on a position when you have grown your account by 1%. Dirks view is you should take profits frequently and use lots of order placed out over a grid to open positions.

Entries and Exits

Dirk’s approach to entry levels is to place a series of trades on the median grid. A single entry order will be placed at Q1, 2 conditional entry orders will be in Q2; 2 conditional entry orders will be placed in Q3; and a single conditional entry order will be placed in Q4. Q1 and Q4 typically only have single entry orders in them as there is greater risks with these trades. Q4 is particularly nasty, because you can be left with a “hanging position” if the market retreats quickly from the top of the grid and may leave you in deep drawdown if you are not careful.

Orders are placed at any level you want. Dirk doesn’t use technical analysis within the grid and he believes price movement within the grid is random anyway. As a tongue in cheek suggestion he has recommended that you place your orders based on your birthday. For example, if you are born in 67, then you would have conditional entry order at 1.5667, 1,5717, 1.5767, 1.5817, 1.5867, 1,5967.

The only stop is a “disaster stop” for all positions, placed 50 pips or so beneath the grid. The wide stops ensure you stay in trades despite the randomness. However, if a black swan comes along, this disaster stop ensures that you are not wiped out.

In accordance with the “one lot” rule, a maximum of 4 positions are open at any one time. Although if you are hedging, you may have more than 4 positions open.

Profits are taken quickly based on the 1% rule above. For example, profit targets are commonly set 35 pips above the entry level. However, the system has a fair degree of discretion in it, and some traders will leave their profitable positions run much longer in trending markets with a trailing stop.

Dirk does tend to “average down”, meaning that if the price moves against your “one direction” view, he will not hesitate to buy the dip at one of the birthday entry levels.

Hedging is optional. Some traders wear the draw down. Some will hedge by putting a trade on in the reverse direction of the “one direction” about 50 pips below where you entered in Q2, Q3 and Q4. That way if you are left holding a hanging order, the pain is not so bad.

Success Rates

If you read the forums, a number of his students actually have reasonably good results. Dirk is an IB and has access to some of his students accounts and he has posted some of their results here. Others have had some great results. For example, Colin and another 4×1 trader Torsten Kroeger, placed in the top 2 (out of 50 competitors) for the 2007 FX Street Trader of the Year Competition. Another one of Dirk’s star pupils “Joe I”, made 74% in 6 months.

Some of these success rates are not necessarily based on abiding by the 4×1 rules around “one lot” or “one currency”. For example, I suspect the traders who won the fxstreet competition used much more than 4:1 leverage and Torsten traded a number of different currencies breaking the one currency rule. Colin used a significant amount of leverage to really grow his real account last year, before he almost blew it up in December 2007. Dirk admits in one of his postings that overuse of leverage is a common reason for failures among his students in their hurry to make money:

… I close this by pointing to the fact that the real big temporary failures that I have seen that were incurred by 4×1 traders under my guidance were without exception mainly the result of too high leverage, usually combined with a misunderstanding or wrong application of either cost averaging or hedging. Oh yes, and a lack of patience.

The last point around “patience” is probably the most important point. The lack of patience leads people to over leverage to achieve big wins sooner. The other reason why lack of patience costs a grid trader is lacking the faith to hold a position in drawdown that it will eventually recover and allow you to take a profit. This double whammy around patience often undoes some 4×1traders. For example, they open a large leveraged position near the top of the grid, the price then retreats and they are left with a hanging position and a large drawdown. The next thing that happens is they get nervous and they close out the position and take a big loss.

Dirk also points to misapplication of cost averaging and hedging as well a lack of patience as one of the things that a number of traders struggled with. I can see how these things would get people into trouble. If you buy your way into a downward price move believe you are “buying the dip” / buying value / dollar cost averaging, there is a risk that the price dip is much bigger than you thought it would be and you are left nursing a large drawdown. Lastly, if you don’t understand hedging, it is also easy to get yourself into trouble, as you can be left holding a large number of unprofitable positions.

My Experience

I have traded the 4×1 method, but since then I have moved back to more traditional position and swing trading supported by fundamental and technical analysis.  I did this because while I can see how grid trading methods like Dirk’s can make money thru trading volatility – I feel that there are numerous other edges not built into the 4×1 method through which traders can make money.

My success rates with Dirk’s methods was pretty mixed. I certainly never experienced the euphoric highs that some of his star performers hit, but I did make money. I never really enjoyed nursing hanging positions in deep draw down (a common issue with grid trading methods). Also I found Dirk’s discretionary approach maddening at times. For example, when you get into the 4×1 method you find that Dirk talks about pyramiding and hedging, but he never really explains it – so you need to figure out your own approach.

Dirk’s approach works well for some and spending some time on it will help you grow as a trader-however,  I just needed to find my own path. I learned a lot from Dirk’s mentoring. For me, it was well worth doing, but his methods are not for everyone. By all means buy his BWILC book and make up your own opinion.

Next Article

In my next posting on grid trading, I will look at some popular automated grid traders.

This entry was posted on Saturday, July 19th, 2008 at 10:53 pm and is filed under Grid Trading. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.