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.