Many people reference Livermore's tragic end as a commentary on the hazards of speculation. I think that's actually a false correlation... while Livermore was a quintessential plunger, he was also a manic depressive with manic depressive children who had to endure much sadness in his family life. If he were around today, he would almost certainly be on prescription drugs, or have access to them as a backstop... Also, anyone who wants to enjoy true success in trading should remember Livermore's assertion (via Reminiscences), "There is only one side to be on in the stock market - not the bull side or the bear side, but the right side." Perpetual pessimists are fools, as are perpetual optimists. There are times for both in proper measure... an inflexibility of perspective is a sign of ideological distortion and / or mental weakness. The best "plungers" will not be those inclined to plunge by dint of gambling nature, but rather those with a calculated risk taker's soul and a deep and passionate desire to win - even a ferocious desire to win - with the understanding that excellent opportunities do not grow on trees and should be played to the hilt (while limiting risk) when such comes available.
Trading Wisdom 23: Maintaining One's Sense of Insecurity "...I don't like working. I do the absolute minimum that is necessary to reach a decision. There are many people who love working. They amass an inordinate amount of information, much more than is necessary to reach a conclusion. And they become attached to certain investments because they know them intimately. I am different. I concentrate on the essentials. When I have to, I work furiously because I am furious that I have to work. When I don't have to, I don't work. This has been an essential element in my approach. If I knew what was going to go wrong, I'd do something to prevent it. But that is not how things work. Let's face it, there is a boom/bust sequence in the performance of individual portfolio managers also. They get it right, and they do very well, and then they get too cocky, and eventually it catches up with them. I'm not exempt from that. It often happens that when things go well, I relax, and then they start going wrong. The situation can change very rapidly. Either I'm on top of the situation, or the situation is on top of me. That is why one should never lose one's sense of insecurity." - George Soros, Soros on Soros JS Comment: Many investors - and more than a few traders - become overly attached to their positions by dint of how intimately they know them / how much research they have done. Has this ever happened to you? What are the risks of developing expert-level knowledge of an industry, sector, or macro market theme? Could these risks be mitigated by a deliberately generalist "focus on the essentials" instead? Do you strive to maintain your sense of insecurity? What happens when you lose it? Can a healthy sense of insecurity, applied correctly and in the right proportions, be seen as a competitive advantage - or a useful form of risk control? Buy Soros on Soros on Amazon Get Trading Wisdom via e-mail
I'm definitely in pain toward the end of the ride, whether it is the daily 20 mile sprint or the weekly 40 mile cruise. But I'm no Lance Armstrong. He would power up several thousand feed in the California sun, every day, 100 miles or so, to stay in shape.
I think this is demonstrably false. It would imply that two traders with $1 million each and identical risk preferences and methods should place radically different size bets on the same trade, just because one of them had a good run recently and the other had a bad run. But this is nonsense - if you have a 3:1 payoff with a 40% win rate, then two traders with identical capital and identical risk preference must bet identical amounts. To claim otherwise is to say that some other input matters over trade expectation, trader risk preference, and trader capital. The only situation I could accept that claim is if the guy on a losing streak is making poor decisions because of this (in which case they would not be in identical situations). Betting based on past profit is mental accounting i.e. irrational deviation from sound bet-sizing. The only situation I can see it is justified is if you have investors who also use mental accounting e.g. they will not mind if you go from up 100% on December 1st to up 80% on December 31st, but will crucify you if you go from flat on Jan 1st next year, to down 10% on Jan 31st that next year. Identical loss but irrational people (which is most investors) will have different reactions based on coincidental and meaningless calendar/date issues.
Well, Van Tharp talks quite a bit of the "playing the house money" in its Definitive Guide on position Sizing " and also sees it has merits. So do I, it makes sense to increase one's risk with the extra profit. Definitely not the same to lose one's extra profit than to risk one's initial risk capital. The second would get one fired for instance from a bunch of trading positions if they lose their bet - in the last Market Wizard one of the managers would remove his traders' purse if they lost like 5% of their initial capital, but wouldn't mind them taking more risk with their profits, and would it be probably harder to endure emotionnally if one lose their initial capital than the extra profit. Besides claiming to know the expectation on a trade is fishy, so I'd be careful on betting the farm on a single trade (the second farm would appear sounder)
It's not false or irrational at all. On the contrary, it is the only rational and sound way to operate in the real world, for reasons that diverge from the hypothetical / theoretical world. The first mistake is in comparing two identical traders, which creates issues for deeper reasons, though you hint at why this is problematic yourself. With the two trader comparison one can still understand the idea, though, from a risk awareness standpoint. It's not about mental accounting, it is about exploiting conviction-based opportunity while remaining deeply cognizant of tail risk. If one is considering a big-bet trade, then by definition conviction levels are high. (If conviction levels were not high, there would be no consideration - and if one's methodology did not allow for position sizing based on conviction, the question would be moot in the first place.) Within this framework, the central challenge for the discretionary trader is exploiting conviction-based opportunity as fully as possible, while simultaneously reducing mortality risk as much as possible. Thus high conviction levels must be coupled with a profit cushion in order to safely bet larger. Think of it like this: If one has a 55% win rate on average, then the outcome of any given trade (win or lose) can be seen as the flip of a slightly biased coin. Call it 55% heads (win), 45% tails (lose) over a long series of trades. Given the above, there will come periods (weeks, months, quarters etc) when you have an ugly streak of tails. Simply through the vagaries of probability, you will occasionally have a streak of X tails running against you, or an overall outlier period in which the mix of tails (losses) to heads (wins) is exceptionally high. Because this negative outlier potential exists - it is wildness embedded in your results curve - you must be cognizant of mortality risk and excessive drawdown risk in a way that pure theory might not directly address. This means paying attention to your equity curve. To wit, a trader with a cushion of profit in his account has "earned the right to swing" at a conviction based trade because his mortality risk has been reduced. If, for whatever reason, his swing is a miss leading to a long string of misses - and such could merely be a negative outlier within normal distributions - then his profit levels will asymptote above zero, and he will be back to trading small well before any great damage has been done. If, however, a trader swings large at a conviction-based trade too close to the zero line, or, worse yet, below it, then his mortality risk becomes elevated through the possibility that an outlier losing streak kicks in at the wrong time, thus eating through his capital. (Note that psychology issues contributing to poor trading could be a factor here, but they do not necessarily have to be - you simply must guard against mortality risk at all times, whether your psychology is good or not.) When a Roman General won a battle and was enjoying the equivalent of a ticker tape parade, a servant would whisper "memento mori" in his ear - remember you are mortal - as a means of keeping him humble. In similar fashion, one can take conviction-based trades in bigger size with an accumulated cushion of profit because the profit cushion itself reduces mortality risk. It lets you pull in the reins / hit the brakes without permanent damage to your risk capital if an outlier negative streak kicks in when you did not expect it. Trading big without a cushion is like operating a shipping business without cargo insurance and without profits in the firm's bank account to pay for unexpected losses. Without that cushion, one has greater exposure to Fortuna's mood swings, and greater risk of a bad luck streak dealing a crippling or killing blow. So in a sense you are looking at the question backwards in assuming big convictions always warrant big bets. Hypothetically it would always make sense for high conviction situations to be bet large if there was no risk of tapping out... but given the real world, cognizance of mortality risk, not to mention potential threats to mental capital, require that in less cushioned situations the same opportunities are bet smaller, perhaps much smaller. Then, too, there are positive outlier considerations - especially given that winning and losing streaks for a trading methodology are typically not entirely random, and may not actually be random at all. If you are on an exceptional hot streak in markets lately, it may be that conditions are aiding your methodology and that those conditions will persist. If you are on a rough losing streak in markets lately, it may be that conditions are creating headwinds and those headwinds will persist. This is even more reason to be pro-cyclical in one's sizing efforts. By reducing risk when your cushion of profits is not there, you reduce the odds of being taken out and reduce your total market exposure in general terms in periods when results are poor. On the flip side, intelligently increasing risk while all is going well increases the odds of potentially exploiting what poker players refer to as a "heater" or a "sick run," while generally maximizing exposure when conditions are favorable. In sum, because of mortality risk and pro-cyclical factors relating to market conditions, a smart discretionary trader will size positions differently well above the zero line than he will at the ZRL or below it, and it is absolutely rational and logical to do so.
p.s. Strangely enough, the above as described would still have value even if one had an "infinite bankroll" i.e. mortality risk of zero (even though such is never a reality). If two traders with infinite bankrolls were competing in markets, and one used dynamic position sizing while the other did not, the trader who used dynamic sizing would have more favorable exposure levels over time - he would spend more time trading large while trading well, correspondingly trading smaller while trading poorly (regardless of where the poor trading came from) - as such beating the trader who always used fixed sizing and was neither consistently bigger when hot nor consistently smaller when cold. The perceived advantage of making back drawdowns faster (via not trading smaller when cold) would be crushed by the positive competitive outlier of trading much larger in significant rush periods. It is worth it to trade small most of the time, so you can trade big (perhaps very big) into the right trends.
Trading Wisdom 24: No Time But the Present "If you have an inflexible image in your mind of an opponent, then whenever he changes, your evaluation of him will be wrong. If you have an inflexible image in your mind of yourself, then whenever you change, your evaluation of yourself will be wrong. For up-to-date evaluation, there is no time but the present." - Tommy Angelo, Elements of Poker JS Comment: Some traders develop an ideologically fixed or emotionally rigid view of the market and refuse to budge from it. How flexible are you in adjusting your perspective? How attuned are you to inflection points, catalysts, and shifts in sentiment based on new information? Do you have a process for stepping back, taking a deep breath, and recalibrating in the moment? How often do you self-grade and self-assess? Is it often enough? Buy Elements of Poker on Amazon Get Trading Wisdom via e-mail
The below shot is the fire pit at the Lone Eagle grill on Tahoe's North Shore, where Chris sat with us ( Jack and Mike) for an hour or two, enjoying a few drinks and swapping trading stories. Chris mentioned how, in the Los Angeles area (where he is from), there aren't a lot of great options for trader meetups. If you know of anything cool going on in the LA area, send us word (jack@ or mike@) and we'll pass it along to Chris. Speaking of meetups, we plan to do a lot more traveling - and informal events with Mercenary community members - in 2013. Whether you are East Coast, West Coast, or somewhere in the middle, you may find us headed your way for a regional WSOP event (to clean up in the extra juicy cash games). You'll recognize us by our Mercenary gear and our habit of catching up on market research at the table... look for more details in future missives like these. If you want to meet us sooner rather than later, we would love to see you at the Wynn in October, where we will be attending the Alternative Asset Summit - also speaking - and the new hedge fund manager boot camp. You can find_more details on that here." No firepit photo attached. Please post here.