I want to talk about position sizing this morning. Not only is position sizing the key to making money in the markets I have a feeling its what is causing these violent swings we've been watching since Mar. I have a feeling that not only the bears but many of the bulls are taking on too much risk. When the markets move very much in one direction all these investors with too much leverage can't hold on to their positions and we get a lot of people bailing out of positions all at once. The Feb. 27th decline was a good example. In the last month and a half we've had 3 days where the SPY has traded over 200 million shares on one down day. That's over 30 billion dollars changing hands. I don't see any reason why a mere 3% drop in the market should cause such widespread exiting of perfectly good stocks. Well actually I do see a good reason for it. I think way too many people are leveraged maybe 2:1 with SSO or more likely with options. If your leveraged with a double fund like SSO or QLD then a 3% move in the market will cost you 6%. Not the end of the world but not a pretty sight on the old account balance. However I think it may be even worse than that for many investors especially novice investors. With the explosion in derivatives I believe too many novices are playing with fire and have absolutely no clue the danger they are in. Lets say you are leveraged 5:1 with options. Well that meager 3% move just cost you 15% of your total portfolio. Now that one hurts! That's like stubbing your toe on the way to the bathroom in the middle of the night. There's a good chance that other people in the house are going to hear about it. I suspect quite a few are leveraged more like 15:1. At that kind of leverage you just watched as half your portfolio evaporated in 3 days. It works the same way on the short side I suspect that way too many people were not only betting on the market correcting Thursday but were also leveraged pretty heavily under the rational that well if the market broke out to new highs then it wouldn't be by much so they would get out with a small loss if they were wrong. Well the market didn't just break through resistance, which in itself started the short covering but it just kept going. All that leverage caused extreme pain for the leveraged shorts so more and more investors couldn't hold on through the pain as the day wore on. The end result is the strongest one day gain in years. Now I could have had my whole account short on Thursday and only lost a little over 2%. Definitely not the end of the world.
This is the thought process that goes through my mind every time I take a COT trade. Hmm... I know the COT produces a winning trade 3 out of 4 times and I know it averages much larger winning trades than losing trades but I just know this is going to be that one trade that ends up being a loser. So if you know that you are going to lose what's the rational thing to do. Bet small of course! That way if you are right and this is the 1 in 4 losing trades you won't do much damage to your account. However if the odds come to your rescue then congratulations you just made money. So what if you didn't get rich in one month you also didn't get poor either. Getting poor is the more important consideration don't you think?
2 months ago