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Blowing out accounts. A look at position size and emotion. Best friends, or worst enemy?

12/13/2010

I haven’t posted a rant since I heard Cramer tell his sheeple to buy gold at its last relative top, so I thought it was about time for a new one. This post is devoted to the emotional aspects of trading and blowing out accounts. When we get a grasp on our emotions, and our position size, we are that much closer to making money in the market.

I hear a lot of people out there talking about how they lost a ton of money trying to learn this game, how they blew this account and then that account and then another account. This is almost like a rite of passage for some. “Oh ya, I blew 5 accounts”. Sometimes these hypothetical people figure it out and start doing pretty well in the market. Sometimes they join the – whatever that magic statistic is – somewhere between 80 and 95% of the people out there who throw in the towel, decide the dream of exorbitant riches, a Maserati and a big house on the beach just isn’t possible, or not worth all the headache. Don’t get me wrong, I have nothing against people with real jobs and of course trading isn’t for everyone. This game takes a special kind of mindset. When talking to my mom about trading, she more or less gets what I’m saying, but the conversation usually ends with something along the lines of “it’s good you know what you’re doing, because I don’t have the nerves for it”. This is someone who raised four kids saying she doesn’t think she has the nerves. But it takes a different type of nerves to sit through watching your account balance fluctuate by a few hundred or thousand dollars in the matter of minutes.

I don’t know if trading is possible for everyone. Joining the NBA or NFL isn’t possible for everyone. But unlike sports teams, in trading we are largely in charge of our own destiny. No we can’t control the market. No matter how much we want the Euro to keep tanking because we’re short, wishing doesn’t make it so. But, we can control how we trade. If we learn to control the right aspects, we can be very profitable.

Back to my main point, what I love about this game is there are no surprises. Ya you heard me right. There are no surprises in trading currencies. There, I said it again. Now, I’m going to say something even more controversial. I have never blown out an account, or come close. Furthermore, I don’t understand why anyone would blow out an account.

Ouch right? I probably just pissed off most of my trading friends by saying that, especially for the analysts amongst us who constantly explain why the market missed THEIR expectations (why not just say, oops I was wrong???). But stay with me. I know a lot of successful traders who have blown accounts, and psychologically of course I understand why this rite of passage exists. We need to learn first hand, and financially, why the market is deserving of our respect. But we don’t have to “blow an account”. For me, it wasn’t a whole account; it was just a 30% drawdown that made me return to the drawing board. That was enough to scare the crap out of me and make me actually learn what I was doing.

Lets see why people blow accounts. I’m going to take a hypothetical trader.

I’m short the euro with a, rather large 50 pip stop. I’m new at this game and don’t really understand position sizes, but I know I’m right. I’ve done great on my practice accounts and I’m ready to tackle the real thing. I did my homework and I know this trade is going to work. I’m targeting 150 pips and I’m going to make a cool $3,000 on my $5K account. And once I do that, I’ll finally have enough equity to actually trade with. (sound familiar yet). What’s that equal folks? 2 full standard lots. What does the price do? Naturally it moves in my favor for 20 pips or so. I’m a genius, I’m going to be rich, I’m up $400 in just 20 minutes. This game is simple. I don’t know why everyone complains so much. Plus, I’m exhausted, it’s like 11:30 PST, so I’m going to bed. I wake up having drempt of ways to spend all my $$. I turn on my computer expecting to see my perfectly executed plan having come to fruition.

To my horror, I’m down 40 pips. I’m not exactly sure what a pip is, but I know $800 is a lot of money to be down. I bite my nails. I swear at the market. I make a deal with God that if I’m just able to get out of this trade at break even I’ll be more careful next time. Fortunately, price turns around. -30, -25, -5, break even. My palms and forehead are dripping sweat onto the keyboard I’m hunched over in anxious anticipation. I’m glued to my computer screen willing the Euro to go in the direction it’s supposed to. Finally, 12 terrifying hours later, after being glued to my computer all day, coffee cups stacked up on the desk, I’m finally up $800. Thank god, that was close. I’m closing out this trade. That was way too scary.

We all know what happens next. Price proceeds to my target just like it was supposed to last night. I’m not sure if I should be thankful or pissed I didn’t catch the whole move. All I know is that my original analysis was spot on. Thank God, I was right. Next time, I won’t close out so early. I’ll stick to my guns.

In the next trade, Mr. Brilliant here isn’t so lucky and he takes a big loss. That’s not cool. Next he gets mad at the market and himself for being so stupid on the last trade. “I’m going to get back at you Euro. I’m not going to let that happen again!!” Naturally, my hypothetical trader eventually blows out his account. Being the rational individual he is, he either deposits more money or gives up having learned nothing except that trading is impossible. He’s lost $5,000 – There goes that trip to Hawaii with the wife. There goes an entire month’s salary at his real job. Worse yet, he tells all his friends how impossible it is and discourages someone who would make a great trader from reading that book on Forex he just bought.

I’m sure we’ve all experienced this to some extent. I know I have.

It always amazes me that in a game where we risk hundreds or thousands of dollars every day, how much even I find myself scoffing at a $50 dollar book. The price of education is high. But the price of ignorance is often much costlier. Why should I read a book on theory when the markets are busy moving around. Shouldn’t I be watching price and soaking “trading” into my being? That’s sort of like saying, if I just sit in this classroom where the teacher is teaching Calculus in Chinese long enough, not only will I learn Mandarin but I’ll figure out how to integrate E^(-2X). In order to learn this game, an incredible investment in time and sometimes money is necessary. The more we spend on the former, the less we will be forced to spend on the latter and the time we spend looking at charts should not take away from the time we spend analyzing strategy. Don’t just look at current price movements, look at past data. Get acquainted with what has worked in the past and what hasn’t. Of course, make sure you have a system that works but most importantly, realize that just because a trade fails a few times, doesn’t mean it won’t pay out big next time.

So what’s wrong? Our undisciplined trader obviously doesn’t know what he’s doing. He failed to control two fundamental aspects of trading. Position size and emotions. When we learn to trade, we have to come up with a system that works. There are plenty out there. In fact, making money is pretty easy. Keeping it however, isn’t. The most important thing we can control about this game is how much we lose. If there is a magic number, it’s probably somewhere between 1 and 5% of our account balance per trade. Personally, I tend a lot close to the 1% side. With most trading styles, I can see losing 5 or 6 trades in a row and still have a solid system that will work in the long run. The key is to get to the long run. This game is not a sprint where I have to make my millions tomorrow. I’m happy making them over the next few years. And besides, a 30% drawdown is not fun for anyone.

You’ll never get anywhere only risking 1% per trade you say? Play with excel a little and see what you come up with if you compound this a hundred times or so. I was surprised at the results when I saw them. (email me if you want a copy of the spreadsheet)

Anyway, we call this trade management. Mathematically, risking 1-3% of your account balance is reasonable. I can stand losing $300 on a $10,000 account. If I risk 3% per trade, I would have to lose 23 trades in a row to have a 50% drawdown and over 100 trades to “blow” the account. (play with {X = X1 * (1-%traded} in excel where X1 = account size and X = ending balance.) It takes a long time to draw down the account. Pretty cool huh?

That’s the biggest problem with trading. The “cool” part. We have to keep cool. And that’s also the hard part especially in a game where, on the outside, it looks like we should sleep our way to 20% / month. Sure, we can make that much, but it isn’t as easy as it seems. Using this risk management, obviously I’d have to be a complete novice to blow an account. I’d have to break my rules, trade with my emotion, take too much risk. I’d have to show that market who is boss…. I’d have to show all my friends who say trading is for fools and gamblers that they’re wrong…. Oh ya….

That’s the mindset that gets traders, the “I’ll have to show” mindset. The greater that concept is ingrained in our trading the lower our account balance goes. “Showing” your buddies will come in time as your account grows. But it won’t happen right away. And, “showing” the market or the “evil brokers” who is boss will never happen. You’re NOT that important! The market and the brokers don’t care about you. They don’t care if your account goes up or goes down. (Well, actually, in the long run brokers probably want you to MAKE money. But that’s a topic for a different post.)

In my next post I think I’ll address my biggest accusation here that THERE ARE NO SURPRISES IN TRADING. Now, we all know that statement is completely absurd right? Check back to see what I’m talking about.

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6 Comments
  1. shoaib permalink

    very nice article !!!

  2. hiteshrup permalink

    Dear,

    Why can’t you upload the excel file for this post; it really help to others.

    Regards,
    Hitesh

    • I can upload a few excel sheets maybe next week. Email me if you want the actual .xls file to play with.

      Thanks for the comment

  3. rob permalink

    really nice article..i would like a copy of that excel sheet please! rkanani90@gmail.com

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