Know Your Leverage, Know Yourself
Two of the defining characteristics of day-trading index futures vs. day-trading the index ETFs are the ability to trade frequently and the ability to use massive amounts of leverage. I’ll examine the second point, first, and the first point, second.
Know Your Leverage
The ES is the CME’s E-mini S&P 500 contract. This is a cash-settled futures contract with each 1/100th of an index point being worth $0.50, although it trades in 25-basis-point increments worth $12.50 each, and each “big point” is worth $50.
With the index trading at around 1325 on Friday night, that meant each ES contract would be controlling or tracking 1325 x $50 = $66,250 of stock value. Buying or being long TEN of these contracts would mean that one was placing a 2/3 of a million dollar bet on the index’s movement. How big a bet that is, depends on your account size, doesn’t it?
The amount of leverage employed per contract is a function of how much cash anchors each contract. As a decent rule of thumb, futures brokers at the retail level will set a minimum overnight margin amount (the cash anchoring a futures contract if held overnight) equating to somewhere between 15 to 25 times leverage. This means that an account as small as $2,650 to $4,417 could hold one contract overnight.
Imagine a trader making that hypothetical 2/3 of a million dollar bet, a 10-contract position, last Friday near the close. Since the S&P 500 futures moved around 60 points or so, that’s roughly $30,000 dollars of unrealized losses based on $50 per big point. It’s “only” a move of 4.5% or so. Take a look at how that plays out with various account balances:
$2650 cash/contract = 25 times leverage. $30,000 loss = 113% equity loss.
$3313 cash/contract = 20 times leverage. $30,000 loss = 91% equity loss.
$4417 cash/contract = 15 times leverage. $30,000 loss = 68% equity loss.
$6625 cash/contract = 10 times leverage. $30,000 loss = 45% equity loss.
$13250 cash/contract = 5 times leverage. $30,000 loss = 23% equity loss.
$66250 cash/contract = 1 times leverage. $30,000 loss = 5% equity loss.
Know Yourself
I’m a lot more of a wuss than I thought I was three years ago. I don’t like drawdowns more than 20-25% or so after extended moves, and I design my systems and contemplate my use of leverage with that in mind. To a large degree, I cope with the emotional side of market moves by abstracting it into a system I’m trading, and trading a backtested and documented system keeps me from reacting to the market out of emotion, which I’ve found is usually a bad thing for me. I’ve focused on finding an edge and applying it repeatedly. I never was one who got an incredible thrill out of the act of trading, and what thrill I did get has kinda worked itself out of my system in the past three years. I view system design as a challenging game to figure out, but I view trading as a business with potential to generate income, give me an early retirement, and build my net worth.
How about you? Do you have an edge? For what it’s worth, I do believe that day-trading strategies can be very successful, and even a small edge can be exploiting into very high Sharpe ratios over time, simply because of the activity level. The key is, do you have an edge? Is it codified into a system? Have you backtested your system to determine its likely drawdown? Are you enough of a “tough guy” to handle lots of leverage and a high drawdown? I would submit to you that, if your system generated a single trade that could effectively wipe out your trading equity, and knock you out of the trading game, then you needed a better system.
What do you get out of trading? Is it the thrill? I would suggest that if you’re a retail hack like myself, but:
* you’re the type to trade the ES (or any other contract) more than, I dunno, ten or so different times in a morning
* you’re not using a dedicated, backtested system, and
* your best trading day ever was so large, it equated to 1/3rd the amount of loss it would take to knock out your account,
then
YOU ARE NOT A TRADER – you have a gambling problem.
Get help now, or find some other risk-taking venture in which to work out your frustrations with: skydiving, hang-gliding, shooting your slingshot at lions in the zoo at night, SOMEthing other than trading!
Seykota is fond of saying that everyone gets what they want from the markets, and the best evidence of intention is what you get. A good friend of mine, “Pond-hopper George,” once told me that a rationalization is when I take a shitty motivation for doing something, wrap a “good” motive or two around it, and eat it, pretending that a shit sandwich doesn’t taste like shit. I believe those three things, whole-heartedly.
The point? When someone comes to the market without a clearly-defined method, blows up from using too much leverage on a single trade, a trade which was known to be an account-threatening bet when it was made – then I believe that person didn’t want to make money, or at least, that money wasn’t their primary motivation for trading. I believe that person wanted the thrill of the game, the excitement and ego-boost of the big score, and was using trading, at least primarily and at the moment of blowup, as a venue to work out some serious emotional issues, primarily related to risk-taking.
This is by no means a phenomenon limited to retail traders or day-traders. Think about the unbridled arrogance of LTCM, Victor Niederhoffer, Brian Hunter, and others; they had their own issues, actually, probably, still have them. When trading becomes an ego play to prove how good or how smart you are, it’s not trading anymore. Combining that attitude with leverage is like taking your Vicodin with a quart of tequila. Trust me, I know.
Two Lessons, Summarized
Know your leverage. Know what level of adverse move is dangerous to your account, and whether or not you can stand that kind of move. Just because your broker lets you use that much leverage, doesn’t mean it’s a good idea.
Know yourself. If you’re in the markets for the wrong reasons, get out. If you’re in the markets for the right reason, find out enough about yourself to develop or follow a method that has a quantifiable edge, that you’re comfortable following, and that feels right to you. Don’t try to be something you’re not – no one will look down on you for going the passive index route; better that than have your courage admired by your friends while your account is empty.
January 21st, 2008 at 6:35 pm
You watched the HPT video too, eh? Yeah he was way over-leveraged and not too smart on risk management.
Regarding your 40% to cash reallocation, I think you got your answer why its doing that.
Here’s to the stock sale coming up. Loading up!
January 21st, 2008 at 6:41 pm
I assumed some readers would know, but I changed the example to the ES and didn’t link because I didn’t want to look like I was “piling on.” But there are some important lessons to be learned, and I think the more rational traders need the leverage lesson, and the more emotional traders need the self-awareness lesson.
Disclosure, some of the systems I track are in cash, but the system I’m trading and tracking is about 30% commodities, 10% Euro, 10% long Ts, and 50% stocks, of which most are Asian.
I have no qualms about adding to the account when it looks more like a bottom has been reached. Right now my drawdown from peak equity is 10%, the third-largest I’ve had since I started.
January 21st, 2008 at 7:47 pm
Actually, Victor is back in the game, and doing quite well.
I hate those mini’s, and prefer the regular S&P contracts.
I fully expect to have a huge day tomorrow, unless there’s a major spike. My only positions that worry me are my grain positions. On Oct 19, 1987, grains were all limit down as people were selling grains to cover their margin calls in the S&P.
Jeff
January 21st, 2008 at 7:59 pm
Vic again? He wiped out once with negative equity years ago, and folded some funds with significant drawdowns last year (but at least with some equity left). Are you saying he’s already managing money again???? I can only wonder who would give it to him … he must be a very personable person, to talk people into managing their money, with his track record.
From when I was checking out brokers, the minis or the full were the same amount of implied leverage given the margin they wanted, and on my timeframe they would be essentially the same to me. I’ll look again at using futures when my account size is MUCH larger, as I’m interested in substantially LESS than the contract-implied leverage.
I’ll probably be down tomorrow, but reference comment #2 re: drawdown and adding equity. Gotta be in it to win it.
January 21st, 2008 at 8:05 pm
New Yorker article on Vic’s 2007 blowup.
January 22nd, 2008 at 8:22 am
What they don’t mention is that Victor had returns of 30-50% per year for the previous 20 years before he blew up. He has a lot of ego, and a lot of people don’t like his confidence and take it as a sign of arrogance. However, whenever you’re #1, that’s a bearish indicator for the individual. There’s always a faster gunslinger in town.
Jeff
January 22nd, 2008 at 8:51 am
You may know or be friends with Vic, for all I know. I know the record but not the man, and this isn’t personal, it’s just my assessment, based on what I know.
I place his firm starting in 1980 and his trading with Soros from 82-90, with returns for his funds from 1980 to 1996 at 35%. It seems impressive. Obviously, there’s something seriously wrong with his methodology or mentality, because his firm’s 18-year compounded return was less than zero percent.
I’ve read a lot of Niederhoffer. It’s obvious to me from what he’s written about random walks, trend-following, and value investing, that he hasn’t examined them rigorously and with an open mind – which is a shame, because on the surface he claims to have a scientific attitude towards the markets. It’s also apparent from looking at his trading style that it is deeply flawed in terms of risk distribution.
When a young, inexperienced trader blows up because they think they’re right and bite off a trade that’s too big for their britches, it’s one thing. When a guy who’s been managing money for 18 years, and trading for longer, does it, that’s a horse of a different color. Someone like that is very unlikely to learn any lessons or make any changes. He’s a loose cannon with other people’s money, and apparently with his own. Witness, 2007. He hasn’t learned his lesson. He’s blown up TWICE. If he gets another shot at managing big money, I think it says more about Wall Street attitudes, and his salesmanship skills, than it does about his ability to trade.
I don’t mind confidence. I like to see a brash, egotistical trader, provided they’re egotistical for the right reasons, like survival and good results. What’s Vic’s cumulative returns since he started managing money? Less than zero percent? How about since he resumed managing money? Including the crackup in 2007, was it even as good as breakeven? He has got absolutely no basis for being confident about his market skill, in my opinion.
As prima facia evidence that I believe properly placed confidence and egotism are to be admired, I’ve spoken well several times, including in this post, about Ed Seykota, who is just like Vic in having a whole lot of ego, confidence, and a very off-putting attitude for lots of people in the industry, except Seykota has a clue about his own psychology, trades scientifically, and exercises risk control. Those are some big differences.
January 22nd, 2008 at 3:55 pm
years back in my undergrad, a professor of mine mentioned in passing that people would rather have their money managed by someone who has done it and failed than someone who hasn’t but has the likelihood of succeeding.
I would accept the argument that Vic is anecdotal, as well as many other popular names you could pile on, but I still think that statement is largely if not wholly true.
January 22nd, 2008 at 4:55 pm
Yeah, see the last sentence in P #4 of comment #7.
At it’s root, I think, is a common psychological herding aspect. They’d rather fail conventionally than risk the public ego-bashing that would come from an unconventional failure (or even an unconventional pleasant result that was less than a smashing success), such as giving big money to someone who hadn’t managed that sum before. So they increase their chances of failure by chasing what is acceptable to their peer group. “Everybody gets what they want from the market.” – Ed Seykota.
There’s no logical explanation, other than “They prefer peer acceptance to performance.”
Hmm, hypothetical Manager X with a backtested method and 5 audited years on his own account, and 3 years on a $5 mil. “friends and family” trust fund. Good measurables, limited use of leverage, diversified instruments, and a transparent system.
Nahh! Let’s go with the guy who has blown up his funds twice, nearly blew up his funds another time, lost 75% of his own money in a day when gold crashed in 1980, trades discretionarily with extremely poor risk and leverage control, and has a lifetime CAGR (combined annualized growth rate) of assets under management that’s below negative 100%! After all, he’s a household name that’s been in the business for three decades …
January 22nd, 2008 at 11:21 pm
Bill,
I read your post and comments on tradersfeed. I’ve been trading over 2 years. Why? So I could lose all my money, look like an idiot on the internet, and become depressed? I’m sure you knew like everyone else that the futures were going to go limit offer over the weekend with YM down -650 pts, because its never happened before. I’m sure everyone backtested the crash of 1987 and no one was long going into that day, because it’s stupid to hold positions overnight. My big EGO discretionary trading method netted me over a 400% return last year, but I’m sure your backtested system was far superior with no drawdowns. I do agree it was a stupid trade I made, far over leveraged. But please don’t go saying I just lost my account for fun and some type of EGO boost.
January 23rd, 2008 at 5:55 am
If you were in this to make money, you’d nut up, stop blaming the circumstances, and take responsibility for your own trades.
That’s not the first trade you’ve taken, which could have wrecked your account. It won’t be the last. You’re a margin call waiting to happen. You may get lucky and not have it happen to you; then again, you may not.
You’ve got more issues than Playboy. You might try facing them.
January 23rd, 2008 at 12:02 pm
[…] Check yourself […]
January 23rd, 2008 at 12:12 pm
Well Bill why don’t you nut up and admit your models are lousy. You spend lots of time backtesting and posting charts and yet are still long and riding this down? What’s really annoying isn’t that you post crap on your own blog but go on other blogs and post your drivel. How about acknowledging the concerns that Barry, Mauldin, and Hussman have been warning about are actually real and in effect? Nah, your time is better spent doing backtesting.
January 23rd, 2008 at 12:36 pm
Brian, dontcha know you gotta go a “full cycle” first?
ROFLMAO!
January 23rd, 2008 at 12:37 pm
Ouch
Tough Love. You sound like pops.
Bill keep in mind no matter how careful you are or what you do, inexperience will lead you to do these kinds of things. Yes it was a dumb trade from a risk perspective, and he most probably should have know better. But we’ve all been there. Especially many of us who trade from home. We don’t have any guidance that most people have at a firm. So these things are natural. It would be ideal to cap the mishap at a small percentage of you account but the lack of the right type of software can force you to lean on your emotions. Sadly most humans are much more optimistic than what reality calls for.
But the real question is what do you do once you’ve experienced this blow up? Experience can teach you better than any book or blog out there.
There are very few people who have your attitude about trading. So it goes back to how do you control the daemons that rule your account. I happen to think much like you that learning how to trade and coding your system is the best way for most traders. It’s helps you control risk and profits. Things that most traders fail to do properly without blow ups and lots of regrets.
Good post for most people to read about the value of risk and sizing.
January 23rd, 2008 at 10:26 pm
[…] Bill Rempel, a.k.a. NO DooDahs! » Know Your Leverage, Know Yourself - This is great advice. To me the real interest is not just that there will be people who blow up because they are clueless but there are people who actually understand effective risk management ideas and their nescessity but still fail to follow them […]
January 28th, 2008 at 7:36 pm
Yo, gotta echo LP here…and although this thread is dead in blog time, I have to say that I would caution anyone from being to rigid in their ideas about what proper trading is — and what proper markets are. If everyone thought or traded alike, there would be no alpha. I’ve traded long enough to know there is no easy answer for why we make mistakes or why we lose. We can come up with pages of analysis and yet, when that next trade comes along, all that information is of little value. I know that mechanical models have their own drawbacks. As does trading professionally. And although metrics like CAGR are helpful in a certain context, at the end of the day they are really just DooDahs.
I wish HPT well. I am confident he will not repeat the same mistake again — at least in the same way. :P
January 28th, 2008 at 8:17 pm
Re: “alpha.” Outside of a regression equation vs an appropriately-chosen benchmark, the terms “alpha” and “beta” are meaningless. The current over-mis-use of the words has resulted in a curious form of financial jabberwocky, wherein everyone uses the words but nobody knows what anyone else means. Interestingly, when used properly (as the axis-intercept and slope of a regression line), the words have a wonderful, concrete interpretation that is filled with explanatory power about a manager’s returns. Shame nobody uses them properly … alpha is a measurement, a metric, not some mythical “holy grail” that traders split between themselves. One could just as soon say there was only so much CAGR or Drawdown in the world …
All good trading has the same elements in common: an edge is applied repeatedly, with enough risk control to avoid going bust. All bad trading has one or more of the following elements: lack of an edge, failure to apply one’s edge, or poor risk control. This is true whether the system is mechanical or discretionary, regardless of timeframe, and regardless of the issue being traded.
There are pros and cons to every system and style of trading. I suppose people who are playing games of “Why does this Always Happen to Me?,” or “Look How Hard I’ve Tried,” or “Super-Trader” will always get some kind of emotional satisfaction to balance out the money they’re losing. Ditto with those who sell the bottoms; they get the emotional release of no longer having to worry about their positions as compensation for missing the recovery.
I wish HPT well, too, but I wouldn’t bet money on him avoiding another blowup.
January 29th, 2008 at 9:56 am
Wow, this blog isn’t dead after all.
I think we both understand what alpha means. But the point is well taken anyway. Our different metaphorical standpoints notwithstanding, I can’t and won’t quibble with the lexical one.
I’ll just come out and say that I wouldn’t bet money on HPT not having another blowup *and* I wouldn’t bet money on your returns equalling his on a yoy basis.
I say this because, at the end of the day, I think I assume he will learn from his mistakes and you think he won’t. No matter how you dress this one up with metrics, pop-psychology and other doodahs, it all comes down to the probable — which in this case isn’t easily measured.
I changed my mind from what I wrote above. I’ll make a friendly wager with you that HPT will not have another blow up within two years. For a daytrader, that’s pretty good. A small gentlemen’s bet of $100?
January 29th, 2008 at 5:28 pm
Why do YOU think that I would want to bet against something that I was actively trying to make happen?
I would really like to see him pull his head out of his ass, quit playing games, set some realistic objectives, develop an edge, practice some risk control, and become successful. I’m not convinced that he will actually DO all of that, but I would I would like to SEE him do it.
From where I’m sitting, he needed a swift kick to the keister more than he needed another “attaboy.” Your opinion may vary.
July 31st, 2008 at 7:47 pm
[…] for size, and settle for the one(s) that best match their logistics and temperament. For example, action junkies should take up skydiving and not day-trade futures, and busy people with families and work commitments should think about mechanical trading on EOD […]