A financial blog on investing in stocks, commodities and the gold bull market.
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.
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T1. A move followed by a sideways range often precedes another move of almost equal extent in the same direction as the original move. Generally, when the second move from the sideways range has run its course, a counter move approaching the sideways range may be expected. T2. Reversal or resistance to a move is likely to be encountered: - 0n reaching levels at which in the past, the commodity has fluctuated for a considerable length of time within a narrow range - On approaching highs or lows T3. Watch for good buying or selling opportunities when trend lines are approached, especially on medium or dull volume. Be sure such a line has not been hugged or hit too frequently. T4. Watch for "crawling along" or repeated bumping of minor or major trend lines and prepare to see such trend lines broken. T5. Breaking of minor trend lines counter to the major trend gives most other important position taking signals. Positions can be taken or reversed on stop at such places. T6. Triangles of ether slope may mean either accumulation or distribution depending on other considerations although triangles are usually broken on the flat side. T7. Watch for volume climax, especially after a long move. T8. Don't count on gaps being closed unless you can distinguish between breakaway gaps, normal gaps and exhaustion gaps. T9. During a move, take or increase positions in the direction of the move at the market the morning following any one-day reversal, however slight the reversal may be, especially if volume declines on the reversal.
General Trading rules
G1. Beware of acting immediately on a widespread public opinion. Even if correct, it will usually delay the move. G2. From a period of dullness and inactivity, watch for and prepare to follow a move in the direction in which volume increases. G3. Limit losses and ride profits, irrespective of all other rules. G4. Light commitments are advisable when market position is not certain. Clearly defined moves are signaled frequently enough to make life interesting and concentration on these moves will prevent unprofitable whip-sawing. G5. Seldom take a position in the direction of an immediately preceding three-day move. Wait for a one-day reversal. G6. Judicious use of stop orders is a valuable aid to profitable trading. Stops may be used to protect profits, to limit losses, and from certain formations such as triangular foci to take positions. Stop orders are apt to be more valuable and less treacherous if used in proper relation the the chart formation. G7. In a market in which upswings are likely to equal or exceed downswings, heavier position should be taken for the upswings for percentage reasons - a decline from 50 to 25 will net only 50% profit, whereas an advance from 25 to 50 will net 100% G8. In taking a position, price orders are allowable. In closing a position, use market orders." G9. Buy strong-acting, strong-background commodities and sell weak ones, subject to all other rules. G10. Moves in which rails lead or participate strongly are usually more worth following than moves in which rails lag. G11. A study of the capitalization of a company, the degree of activity of an issue, and whether an issue is a lethargic truck horse or a spirited race horse is fully as important as a study of statistical reports.
Investing in the financial markets can involve considerable risk. Past performance is not necessarily an indication of future performance. The information included in The Smart Money Tracker and The SMT subscribers daily updates is prepared for educational purposes and is not a solicitation, or an offer to buy or sell any security or use any particular system. Information is based on historical research using data believed to be reliable, but there is no guarantee as to its accuracy. G.D.S L.L.C., nor Gary Savage, do not represent themselves as acting in the position of an investment adviser or investment manager for funds that are not under their direct control and fiduciary responsibility. GDS L.L.C., Gary Savage, will not provide you with personally tailored advice concerning the nature, potential, value or suitability of any particular security, portfolio or securities, transaction, investment strategy or other matter. From time to time, GDS L.L.C., Gary Savage, may hold positions in securities mentioned, but are under no obligation to hold such positions.