There are a large number of things that could end your trading career early. For example, not having a good financial education. However, this can be compensated for by other positive factors, such as a good ability to understand price action or order flow. I know some very good futures scalpers who are profitable even if they don’t know much about the economy.
There are also other negative factors that on their own will lead to a financial disaster and cannot be compensated for by having other positive equalities, like being very smart or passionate about trading.
Thanks to our naturally positive attitude and tendency to overestimate ourselves, even when we know we are doing something wrong, we often think that it will be easy to avoid the consequences.
For example, some experienced climbers die while climbing mountains in adverse weather because they think they can avoid the consequences of doing something potentially fatal for anyone else because they “know what they are doing”.
The following three potential sources of danger will be equally dangerous for anyone, regardless of their level of innate ability, wealth or experience.
Too much leverage
For retail and for large institutions, this is the most overlooked source of risk in trading.
The higher the leverage, the higher the probability of blowing an account.
During their trading career, everyone will have at least a few bad draw downs. If the leverage is high enough and the account goes to zero, it cannot recover in any way.
I am making things very simple because the message is so important that I want to keep it understandable, even for those who are reading this article by mistake and know nothing about trading. Things are actually bit more complex than that, and a loss bigger than 50 % could be considered too high to be recovered.
There are different reasons why someone might use high leverage.
A beginner will usually open a small account—even too small to start—and think that by using 100x leverage, he will take his £1000 account to $1 million as he has seen in many “get rich quick” advertisements on the internet.
On the other hand, quite a few traders who have been extremely profitable for years may decide to increase their risk, and consequently their leverage, because their confidence in their trading abilities has increased too much.
I have already written an article on how high self-esteem could damage trading performance. Take a look; it could help your financial life.
It does not matter how good the trader is. Sooner or later, an unexpectedly large drawdown will occur—it is just a matter of time.
Let’s think about someone who drinks and drives. It is not easy to tell when he will crash or get arrested, but we all know that sooner or later he will be in jail or hospital (or a cemetery).
Trading can kill accounts, not people, but we can say that a trader who uses high leverage will certainly (financially) die.
From an accounting point of view, the present value of the cash flow generated by trading with too much risk is negative.
From a statistical point of view, the expected value of the discrete stochastic process, trading activity with high leverage, is negative.
In even simpler words: what you could reasonably expect from trading for some time with no respect for risk is a net loss.
Additionally, some large banks have caused trouble for their clients and the whole financial system by assuming that they already had a way to predict how frequent bad events could be. In fact, they assumed that returns in the financial market were normally distributed and then tried unsuccessfully to use the probability density function of a normal distribution to determine what could have happened in the worst-case scenario. What indeed happened, which was much worse, is that the high volatility during 2008 was deemed “not possible” according to institutional risk models of10 years ago (even now, things are just a bit better).
Why do traders think that using a normal distribution is a wise thing to do?
It is well known that daily returns on the S&P 500 are approximately normally distributed, but only if we have enough data. In other words, if we take thirty years, the normal distribution assumptions seem fine, but if we just take ten years, including 2008, it is not fine anymore! As I previously said, what happened in 2008 is in complete contrast with the assumption of normality.
If we look at the daily return of any trading account, the distribution of return is not even modellable. It is always far from normal. It might sometimes look similar to a bell in shape, but the tails are always much fatter than those of a “normal” bell.
Having fatter tails means that extreme events, also known as the tails, are more likely to occur in the real financial world than in a model where things move “quietly”.
In other and simpler words, the risk in a real trading account is way higher and different from the risk of holding a position in stocks of the S&P 500 for a long time. It is also very hard to model and forecast.
When trading, the only thing that I assume is that risk in the future cannot be understood just by looking at how things went in the past. In a nutshell, if during the last few years, you have lost a maximum of 2% of your account by trading futures in a single day, this does not tell you much about what you could expect to lose in the worst-case scenario. A much more complex approach is necessary.
What everyone should do, without having complex quantitative instruments, is a simple stress test. I will describe this later on as this can be extremely effective and very simple to do.
If we had a long over week position in ES futures, how can we know if we have a chance of surviving if very bad news occurs over the weekend when the markets are closed? This is every trader’s nightmare.
A simple solution is testing if the account could have survived an opening in the gap that is equal in percentage to the worst gap that has ever occurred on the S&P 500.
The same thing can be done to position any other instruments.
How could something so simple be a better approach than using a normal probability density function to estimate how bad a draw down could be? It is because by using real data from the past, we are now including the rare events that also occurred but would have been ruled out and not considered using the “classic” approach.
To do this simple “stress test” on a trading account, Excel is more than enough.
Many retail algo traders rely on software that uses a normal distribution to simulate the possible scenarios of a trading system portfolio. This, of course, makes me very sad.
What they do follows approximately this procedure: they “mix” trades from different trading strategies occurring at different times to create a large number of scenarios for what could have happened if trades were occurring in a different order.
I don’t know why, but they usually call it the Monte Carlo simulation, even if it Is a bootstrap.
After wards, they consider the real future risk of their trading system portfolio if it is normally distributed.
If the largest draw down in the past simulations was 3%, they assume that their risk cannot, 99% of the time, be more than 3% + 3 standard deviation, which almost makes me cry.
This approach is totally wrong for two reasons. First, because when they shake all trades from different systems, they lose important information, which is the time order. This makes their simulation unrealistic. Second, the simulation does not contain any information about what could have happened. It could be just by luck that all those systems did not open a long position together the day before a market crash.
A very simple “stress test” done by hand with a calculator would have been more reliable than using those Monte Carlo-looking simulations.
For example, what if I had ten systems holding the same position on the same asset and they all go in stop loss? When the number of systems and markets they are trading in is small, a phone calculator is enough.
If the answer to the last question is a loss lower than 10-20%, it means that the risk you are running is not too high, and in the event of a bad loss, you could recover.
(to be continued )
Warning: There is a risk of loss in trading. It is the nature of commodity and securities trading that where there is the opportunity for profit, there is also the risk of loss. Commodity trading involves a certain degree of risk, and may not be suitable for all investors. Derivative transactions, including futures and forex, are complex and carry the risk of substantial losses. Past performance is not necessarily indicative of future results. Please read additional risk matters on our web site www.londontradinginstitute.com
It is important you understand all the risks involved with trading, and you should only trade with risk capital. This communication is intended for the sole use of the intended recipient and is for informational purposes only. It is not intended as investment advice, or an offer or solicitation for the purchase or sale of any financial instrument.