Wednesday, July 18, 2007
This is going to tie in with the position sizing post the other day. I see this quite often on the blogs how such and such has increased their portfolio 100% in the last month or they added 20% a one day. Sounds impressive...unless you're an experienced trader. If you've been around for a while you know that when you hear someone bragging about those kind of gains you will in the not to distant future hear them say they blew out their account or probably you just won't hear from them any more. Let me say right up front that every system will have periods when it incurs multiple losses in a row. Let me show you what happens to a portfolio when someone is playing with options and leveraging up only 5:1. Lets say you start with $100,000. Now lets assume you give the underlying asset a 2% move before you're stopped out. I'll quickly add that a 2% stop is going to mean you will most probably get stopped out quite often. You're not giving your position enough room to work. Back to the example. Your first losing trade costs you $10,000 ( 2% x 5 = 10%) Now you've just reduced your overall portfolio to $90,000. Not the end of the world by any means and definitely recoverable. However now you take another trade using the same leverage and you lose again. Now your portfolio is down to $89,000. Your down almost 20% with only 2 losing trades. 20% is starting to get serious. The next trade if its another loss brings you down to 72,900. Next $65610 and then $59049. Its not hard to have five losing trades in a row. If you hit that kind of losing streak while using 5:1 leverage you will cut your account almost in half. Now you are in the position of having to make almost 100% on the remaining capital just to get back to even. Now let me give you the sequence at 10x leverage, which by the way is what the more conservative Bear Stearns fund was trading. $100,000-$80,000-$64,000-$51,200-$40,960-$32768. By using 10x leverage 5 losses will cost you 2/3 of your portfolio. But here is the real pitfall. If you get lucky and score a winning trade on your first try then most likely human nature takes over and you say to hell with 5 or 10x leverage I'm going all in, this is easy. 1 loss at 20x leverage will cost you almost half your account. Holy s**t that wasn't supposed to happen. Now I'm down big so I guess I better go all in again and make it back quick. So you take another 20:1 trade again with a 2% stop which already most likely reduces your odds of a winning trade to under 50:50. That means you are staking the remaining $60,000 on less than a coin flip. End result of two losing trades at 20:1 leverage, $36,000. You've lost twice and cut your account by 2/3. Now you have to make almost 300% to get back to even. Do you see now why it is so important not to lose money. If you do lose it better be small. The way to do this is obviously keep your position sizes small enough so that you don't get hurt when you lose.