Tuesday, March 23, 2010

On Dealing With A Bad Trade

During the week of March 8 to March 12, I started to leg into a position that shorts the S&P500. My vehicle to express this bet against the market is the UltraShort S&P500 ProShares (symbol: SDS).

The rationale for the trade is the following: 1) investor sentiment had become bullish to an extreme degree across multiple measures (see this article); and 2) the composite indicator constructed from the trends in gold, crude oil, and yields on the 10 year Treasury had become extreme (see this article). In of and themselves, each of these measures would be cause for caution, but when combined together into a single trading strategy, it seemed like a good bet that a market top was in place (see "Danger, Danger Will Robinson").

So the signal to go short the S&P500 was given on the close of March 5 with the S&P500 at 1138.69. Over the following week, I started to establish my position with several purchases of SDS, and this can be seen in our real time portfolio, which is being monitored by kaChing.com. This is a real portfolio investing real money.

As we know, the position has not gone my way. On Tuesday, the S&P500 closed at 1174.17. From the time of the signal on March 5 to Tuesday's close, the S&P500 is up 3.12%. From this perspective it seems like a lot more as the price action has been all in one direction - up! My real time position is underwater a little less than this.

So let's answer this question: Is this a bad trade?

My answer: It depends. The trade is going poorly but the foundation and rationale for the trade are solid, and I would be happy to take this trade anytime. Of course, I would like and expect a better result. It is a bad trade in the sense that I am presently underwater, but it is not a bad trade because I have followed my plan. Things are just not working out as planned. So I would call this a bad trade, but not the wrong trade.

While the market has been on a non-stop, up escalator, the current trade has experienced a draw down that is at the outer edge that has occurred with past trades from this strategy. In other words, this trade has already moved 3.12% adverse to its entry position. Out of the prior 13 trades from the strategy over the past 5 years, only 3 trades experienced draw downs of greater than 2% and no trade experienced a loss greater than 3%. So the current trade is in new territory here, but not by much.

We can get an idea of how past trades behaved by looking at the maximum adverse excursion (MAE) graph for this strategy. See figure 1. MAE assesses each trade from the strategy and determines how much a trade had to lose in percentage terms before being closed out for a winner or loser. You put on a trade and if you are like most traders, the position will move against you. MAE measures how much you have to angst and squirm while you are in that position. So far this trade has made me squirm about 3%. Because once you close the position out for a loss or a win, you are done worrying about it. As an example, look at the caret in figure 1 with the blue box around it. This one trade lost 1.5% (x-axis) before being closed out for a 2.5% winner (y-axis). We know this was a winning trade because it is a green caret.

Figure 1. MAE Graph

What I have done right with this trade is the position sizing. Although the position has gone against me, I have lost less than 1% of my capital. I based my position size on prior MAE's from this strategy, plus I have added in a bit of wiggle room in case we get a trade draw down that exceeds prior extremes. And this appears to be the case.

So I can sit tight a bit longer. But I also have some options.

The first option would be to add to my position. I won't do this, but there is a good argument that I can make why this might be the opportune time for such an action. We have this strategy and the prior trades from the strategy never had an MAE greater than 3%. The current, active trade has an MAE that is at 3%. I could add to my position here with a very tight stop loss as any price move that is even more adverse to the current position is highly suggestive that something else is going on that cannot be explained by the data. So this becomes a good low risk place to add to your position provided you honor your stops if the position moves further against your entry position.

The second option, which is the way I will play it, is to take no action at present. Although the MAE is extreme, 2 of the other 3 trades that had MAE's above 2% did recover to become winning trades. So why I don't want to trade on hope, the data does support a "hang tight" policy. I still have the conviction that I will be right, so I will continue to exercise trading discipline. If my stop is hit (despite the foundation of the trade being intact), I will exit the trade. I will make a reentry on the trade provided I have price confirmation and the rationale for the trade is intact.

One option I won't exercise is to throw caution to the wind. If I am wrong, that's ok. In my opinion, the key to successful trading and investing is not to be wrong for long.

Honestly folks, do I like having a losing trade? No. Do I expect to have them? Yes. I will be happy if I follow my plan and live another day to take another really juicy pitch.


Goatmug said...

Timely post Guy. I share such as "bad trade" presently. Thanks for the insight.

numbersgame said...

With your system, when do you know you are wrong, ie where's your stop? Seems to be the only piece of info missing in an otherwise informative post.

Guy M. Lerner said...

Easy....I use the MAE to determine a stop % stop loss; in this case, beyond 3% is the stop loss; my thought is if the drawdown for this trade is greater than 3% than something must be wrong, but I also want to give myself some wiggle room so that I am outside the noise of the market....

I hope that clarifies

Anonymous said...

It's irritating, isn't it. While I haven't gone short yet, I have lost money by being too cautious. And yet everything seems to call for a decline! Perhaps the contrary indicator to watch now is not investor optimism but blogger pessimism: the more that clued-up bloggers think a decline is imminent, the less likely it is to happen!

Guy M. Lerner said...

It is frustrating but as I point out in the article....still within the confines of my expectations for this trade

Has anyone seen the move in the Dollar, USD/YEN, and the decline in SLV?

Anonymous said...

A bad trade is one where you didn't follow your plan. That's what you control, not the market...

D-man said...

"Has anyone seen the move in the Dollar, USD/YEN, and the decline in SLV?"

Yep, I did. SLV is up today, btw. I still like USD/YEN on the long side, holding position. Thanks.

Btw, I think you will be stopped out from the SDS. This market didn't corrected (except for yesterday) more than 0.25% in the last 13 days (very very rare occurance). As the savvy investors are cautious, speculators and momentum players are playing "contrarians". Everyone and their sister is contrarian these days...

Guy M. Lerner said...

SLV closed tuesday at 16.70 and closed wed at 16.29; I am not sure I would call that an up move--the math seems a little funny

Guy M. Lerner said...

one other thing on SLV....down from when I first mentioned it at $17....but it all gets into your time frame....if you are holding for the next 5 years then a 5% move adverse to your position shouldn't bother you....if you are playing for 2% then I guess it would matter....I suspect there will be a better opportunity in the future to buy lower

With regards to equities, I think your take is wrong; it isn't a matter of being wrong or right but are you following your plan

D-man said...

"SLV closed tuesday at 16.70 and closed wed at 16.29; I am not sure I would call that an up move--the math seems a little funny"

I have it at 16.79$ today on my screen; maybe we don't watch the same vehicle...

I agree the short was well timed and we're down 2% since the call was made as of today, Thursday 25th of March 2010 (just to be precise here :)).

USD/JPY on the rise again, see if it reaches the 98 target.

Guy M. Lerner said...

SLV is the Silver ETF and is not a short hand for silver the commodity

once again: time frames, brother

D-man said...

"once again: time frames, brother"

ok, but you need to give those than if they are so important. when I enter a trade, I look for when to exit in terms of price rather than time as I can't guess that. I assume you do that as well as your target can be reached within an hour or 5 years, right?

As for the SLV, if I'm not wrong, didn't give a 2% down from 17$. It just gave the direction and the stop loss (the resistance level).