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BookingAlpha Option Trading Advisory

Tuesday, March 15, 2016

Trading Innocence

I have lost money following trading newsletters. I have spent a lot buying what I now know are sub-par and overpriced trading courses. I have wasted time going to conferences. Oh yeah, and I have also lost money trading. Seems that there is no way to win this game, and that everyone who says otherwise is full of shit!! - Ted

The newbie trader is like fresh meat for old inmates. We all go through this stage where our money, and not just our trading account, is in much greater danger due to our innocence.

If you are new to the game, be aware of the following points that make you an easy prey. I'm also listing my own lessons extracted from personal experience during my rookie phase:

1- The tendency to believe in abnormal returns makes you an easy scam target
The new guy "wants" to believe that becoming wealthy over night is quite possible, and that trading full time for a living will just be 2 months away. He won't hesitate to buy sub-par products or subscribe to incompetent premium trading newsletters with no risk management skills.

  • Getting rich over night via trading WILL NOT HAPPEN. 
  • Trading full time for a living takes a lot of experience and being well capitalized.
  • DO NOT blindly believe in returns posted out there.They may not be true, or they may have been a matter of pure luck

2- The rookie disregards important metrics and mostly pays attention to returns only
Ted, blindly looking at returns alone makes the newbie trader an easy prey in the jungle. Statistics other than returns are an important part of the equation when evaluating any track record. What about the Max-Drawdown as percentage of an account? What about the largest draw-down measured in days? The shape of the equity curve also tells you a lot about a given trading style. Other statistics such as the Sharpe Ratio, which tells you how much a performance is a result of more risk taking rather than skill. Or the Ulcer Index, which, if you know yourself, should give you a clear indication as to what might be too risky for you to mentally handle. For example, when back-testing trading strategies, I know I feel comfortable with Ulcer Index values below 6 (In general, around 10% max draw-downs, that last around a year at most). This way I know when I must reduce risk for a given strategy to accommodate it to a smaller Ulcer Index.

  • Learn about other important statistics, such as those related to draw-downs. 
  • Learn about Sharpe. Some people don't like it as it penalizes volatility in the results, both upside and downside, but in real life, upside volatility in the returns is desired and should not be penalized. To overcome this limitation, the Martin Ratio was created. Get familiar with what "good" numbers for these two statistics look like.

3- The new guy will tend to overestimate his pain tolerance
Thinking that you are psychologically stronger than you really are, will lead to taking excessive risks, or bailing out on positions at the worst possible moments. It's not all about preventing the risk of ruin. It is also about accommodating to pain levels well below your max psychological pain thresholds.

  • Whatever you think you are able to psychologically handle, cut it in half and that will be closer to reality when the shit hits the fans. Years ago, I thought I could easily handle 20% draw-downs. Then right at the beginning of 2013, I suffered a 14% draw-down, which reality told me was a bit too much for me to psychologically withstand. I then realized, that about 10% max-drawdown was the comfortable level for me, and modified my trading accordingly. Surprisingly 10% is half what I thought I was able to handle at the beginning of my trading career.

4- Poor Risk Management
New traders put to much emphasis on trade entries, leaving risk management as an after-thought. Paraphrasing Murphy's law "Everything that can go wrong, will go wrong". In the world of trading you have to manage your risk. It always comes down to risk management, not position entries. You can blow your account trading stocks, bonds, forex, options, even if you have the best strategy in the world. It is usually not the strategy that fails you, but the poor risk management skills.

  • Always have a mechanism in place to cut your losses when playing undefined risk positions with options. Even defined risk positions need this for more conservative traders. 

  • Use Stop losses, at least mental ones if you trade stocks or Forex.

  • Have clearly defined exit rules for your positions if you are an investor in dividend growth stocks. No stock is a "buy and hold forever". Only in hindsight, plagued by survivor-ship bias. All stocks are ugly except when they are going up.

  • Don't believe the non-sense of letting a naked position totally play out based on probabilities. Even if you play ultra small, if you let something go against you indefinitely, at one point it WILL START to hurt. And if you play it extra small, it stops making sense. More about that here.

5- Underestimating the impact of commissions
Ted, I only realized I was paying too much after a few months trading. This is obviously wrong. You should know in advance how your broker's commissions will impact you. If you enter a small credit spread on SPY, 5 point wide, 0.5 credit and 4.5 risk (90% probability of success). You will make $50 at most. If you like to manage winners at 50% of max profit, you would take this trade off at $25 gain. Now, if you have a broker that charges you for example $9.99 per order ticket plus $1 per contract, you are spending $12 to get in and $12 to get out. Your $25 gain becomes $1. You are putting risk on the table basically to feed your broker. You are taking risks, whose rewards someone else is taking.

Careful with being too active. Some super active traders make 5,000 trades per year. Assuming you have a $100,000 account, and that each trade costs you, on average, $10 in commissions, let's say $5 to get in and $5 to get out, you are spending $50,000 a year in commissions. You will need a +50% return in the year just to break even. Needless to say, consistent +50% per year are totally Hall of Fame, Elite, non-sustainable-in-the-long-run returns.

  • Use strategies and instruments that will reduce the impact of commissions

  • Find a broker whose commissions schema will not doom your account from the very beginning, giving you no chance to make money.

  • Try to keep your commissions expenses reasonable. Avoid that nonsense of seeing them eat 25% to 50% of your gains.

  • Careful with being extremely active. I could only justify it if you have a 6 - 7 figure portfolio and you are an experienced and knowledgeable trader.

6- Out of Control Newsletter subscription costs
The inexperienced trader may end up subscribing to premium trading newsletter whose cost is too high in respect with their account size (this has probably happened to you Ted). Consequently, the trader may end up overall losing money regardless of the good performance of the newsletter. Suppose you have a $10,000 account, and you pay $100 a month for a newsletter. That is $1,200 per year. You need +12% return on your account just to break even. Trading is our side business, therefore not only trading gains matter. As any other business we have costs: commissions, newsletter subscriptions, etc. Our business's goal is to have positive cash flow after expenses, wherever they come from.

  • Keep subscription costs under control. I would avoid spending more than 5% of my account size in subscription costs per year as it starts to become too much of a drag for your overall performance. Except if you don't care about that drag and your goal is to learn from the mentor for a clearly limited time as a form of investment in yourself.

7-Eagerness to follow others
The lack of confidence will lead you to seek approval, to trade with others. Careful with that. Remember that the majority of traders lose money and even the majority of professionals under-perform the markets.

  • If you are a Forex trader and buy robots, let me tell you that I never found a single retail robot out there that wasn't garbage. Most programmers are not trading system designers and are not too clear about concepts like curve-fitting, rank analysis, walk-forward parameters selection, etc, etc, etc.

  • If you follow Forex trading signals, from a provider in platforms like Zulu or similar, learn why this is such a bad idea.

  • For investors, careful following "hot tips". The "Dividend growth investing" community for example, was recently caught buying KMI left and right just because one of their most popular guys did. Total blood bath.
  • Penny stock traders: the newsletter owner will ALWAYS front run you in both entries and exits. You have next to zero chance of making money in the long run.

  • I guess all this just tells you: Study hard, learn your craft so that you eventually become your own guru.

Ted, I'm pretty sure there is more. But man, this article is already too long and I'm feeling like a pathetic and old nagging lady.

Careful out there my pals!

Related Articles:
The Guru
The Torture
Frustration (Mentally dealing with extended draw-downs)

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