Each time I hear the word
blow-up, my heart paces, and I go thru my trades trying to pick out what could cause it. I do accept my leverage would lead to significant draw-downs (in the last two-years I have had maximum 50% draw-down, part of which is out-of-character behaviour), but we need to make a distinction between a draw-down and a blow-up (a near 100% loss of account from which it is practically impossible to come back without further injection of capital).
What could cause a blow-up?
a) Trading without an edge (positive expectancy) will eventually lead to that. The mere fact there are commissions and slippage will ensure this happens in the long run as long as one continues active trading. This has nothing to do with risk management.
b) Trading at a risk level too high compared to the edge. (As a simple example, if win you get 20% on investment, and loss you give back 18% on capital, and the chances are equal, it is clear this has positive expectancy. But if you play with a 100% leverage (betting everything on account), it is clear this is negative on balance, and will lead to a blow-up.
c) A black swan causes the abnormal to take place. A stock falls from 110 to 44 intra-day on sudden adverse news, you short at 44 with 100% of capital expecting more downside. Stock gets halted, company discloses the news was a hoax, stock resumes trading back above 100 (Emulex EMX hoax of 25 Aug 2000). Instantly you lose 100% of your account and owe your brokerage.
Well I have been in / watched the market since Dec 1999. The first 5 years were my tuition years (showing losses), during which I have seen almost all there is to see in what constitutes risk. I believe I have an edge (attested to by historical results), believe my normal risk level does not lead to a negative long-term result (by the way, I adjust my risk-tolerance based on current trading results. If I suddenly lose the edge, I do not want to keep on thrashing the account balance before accepting it). As for the black swan, while I may take all the measures to ensure it does not happen, I do not think anyone is above such. Even the folks doing conservative buy/hold investing that have lost 60,70% of their portfolio in the current melt-down think they have experienced a black-swan event. I wonder if there would be any futures trader if someone keeps imagining buying an ES long contract (at say $5000 margin per contract), an event happens that halts trading in the market, and the market opens down 20%. There are all forms of remote possibilities, but you can't place your life on hold just because of the slightest probability of a mishap. Reading all the warnings of blow-up make those remote events look like a norm.
One thing I guard against is resisting the temptation to take on risk bigger than my normal well-calculated limit. Everyone accepts that buying an out of money option contract with 100% of account close to expiration is silly, and bigger than any well-calculated limit.
Quote from Cutten:
If you are actually capable of multiplying an account 3fold or more consistently, by taking large risks, then you are capable of making 30-50% per annum taking low risks. If you are capable of the latter, than you are one of the top traders in the world, and all you need to do is raise some capital and start trading it conservatively, and within 5 years you will probably have 50 mill+ under management and be ready to make tens or even hundreds of millions of profits over subsequent years.
I will give some thought to managing money later, but at this time, I really want to be able to grow my funds no faster than I can trade: If I suddenly have 50 million under management, I probably do not have enough trading outlet to utilise all that money given limitations in liquidity.
Quote from Daal:
another factor to consider is that neke probably lost TONS of money by expressing his trades through options and taking a huge cut on the bid ask spread. If he were to lever down and only use his 4-1 retail instead he probably would find his returns smoother and take the risk of blow up off the table.
I mean seriously neke, have you calculated how much more money you would have had you not used options and instead used the underlying stock if you had access to like 20-1 prop leverage?
I think Pita has already answered this, using options is far better that trading prop with 20:1 leverage in terms of risk management. I do not stake 100% of my account per option position: maximum loss is defined beforehand. I do accept there is loss due to slippage, but that makes me more picky in what/when to trade options. Secondly, even if I have 20:1 leverage I will probably be short of ideas to trade. As you see, I make just a few trades per day: I believe - my best idea is way better that the average of my best 20 ideas
