The Seduction of Leverage

Transcription

1 The Seduction of Leverage by Jesse H. Thompson "Leverage 'o Leverage. Ye siren of the speculative sea..." Anon. Rule: Do Not Overtrade! I must have bumped into this time worn dictrum a thousand times before I began to understand more fully the implications of this rule relative to actions taken in speculative markets. Of course, early in my studies I decided this rule was simply common sense and too basic to waste any further time or effort on, So I vowed to never overtrade and simple as that I was through with this rule. (Well, maybe I was through with this rule but it was NOT through with me.) First, I did not stop to carefully define and identify the nature of this great ogre called Overtrading. Being so blinded, I failed to fully master the technique of How not to overtrade! It is not enough to empirically discover or intellectually agree that overtrading or any other trading sin is financially harmful, a trader must acquire the technique of translating this rule into action. A similar analogy can be applied to successful speculation, as it is not merely the' ability to analyze something, it is the further ability to translate that information into a practical and profitable technique of entry and exit. A trading rule like a pearl of a precious necklace can only be strung and truly called yours after you have acquired a thorough understanding of its definition, its implications for action and can integrate this information into your trading operations. Only then can this rule be of great practical value. Close-up on Overtrading Let's examine in greater detail this superb trading rule: Thou Shall Not Overtrade! First, recognize that the cardinal sins of overtrading and the failure to limit your losses (using a stop loss order) probably slay more novices than all other influences combined. Secondly, realize that overtrading is in some part stimulated by the phenomena of leverage. We might define leverage in the markets as the right to control the disposition of an investment or speculative vehicle whose current total value is some multiple of the amount of capital required to secure such right. Now the virtues of leverage we shall let alone, for the ad 1

2 copy of the trade reminds us incessantly of the "tremendous profits" we shall all accrue as a result of the beneficence of leverage. This view is of course one dimensional and it's the flip side of leverage that we should know intimately. The low margins (high leverage) which typically exist on the options and futures exchanges are surely not established to optimize your return on investment, but rather as an inducement to draw a greater number of participants and enhance liquidity. The affectations of leverage on the mind and subsequent actions of the typical trader are without a doubt both extraordinary and pervasive. Treated improperly leverage can be financially disabling and often fatal. The two general effects of leverage tend to be either overtrading relative to time or overtrading relative to capital. Overtrading Relative to Time Overtrading relative to time in this fashion can be generally defined as attempting to trade more swings than the detectable technical conditions you are monitoring normally describe. Overtrading in this fashion is manifested in varying degrees with the most acute case being the popularity of attempting to "day trade" or "scalp" the market. There are two main groups that indulge in this technique of speculation. One group performs this type of trading as a viable business, as they are professional scalpersñ most of which operate on the trading floors of the exchanges. The second group consists mainly of retail customers of various brokerage houses. They usually intend to operate as efficiently and more profitably than most professionals on the floor. As a result the second group mostly generates net losses over time. Why does the second group undertake such a feat? Speaking from my early "daytrading" experiences, I nakedly confess that unbridled greed (an attempt to make an absurdly exorbitant return on capital), impatience and lastly, fear of staying in overnight arising from my ignorance of price action and market activity each shared a leading role. Leverage plays an important role in fueling the attraction toward day trading for if one scans the financial columns noting the ranges of various futures or option contracts, he will find something every day whose range from low to high is such that if one could have sold at such a high and bought at the low (or vice versa) a handsome profit could have been secured in excess of expenses. Theoretically, this may seem appealing, but in actual practice, especially from the retail speculators standpoint, it is probably the most difficult form of speculation attempted. The probabilities of consistent success over time is extremely small. The retail customer trading from quotes in his brokers' office or from a quote machine in his own private office does to some degree have the advantage of physical distance from the emotion of the floor but many who own a quote machine submit that emotion can be highly stimulated solely as a function of your mental processes interacting with the activity of the price screen. 2

3 Disadvantages of Daytrading The disadvantages of the "day trader" are enormous. First, he has to deal with a third person, his broker, as he can not act instantaneously and directly as the floor person can. Therefore, there is an inherent time lag which increases his overhead. Even if the disadvantages of time lag were somewhat equalized by technology he would still have to overcome the potential for much higher operating expenses. He has to maintain the cost and repair/maintenance of a quote machine, the possible costs of a microprocessor and an array of software and data expenses. He might even be paying for the cost of a private office. And of course, his commission costs alone put him at a great disadvantage to the professional on the floor, who pays a fraction of his commission costs. Unlike his competition on the floor, he has the further handicap of not being able to judge the quality of the buying or selling on the floor. Is the market rallying because the professional traders are establishing long positions or is it mostly short covering by retail houses who sold short early in the day? This information may be valuable to the scalper. Lastly, the "daytrader" fails to realize that the real opportunities for a legitimate intra-day trade are less 3

4 frequent than one supposes, as accumulation/distribution and the technical condition is not poised in such an ideal manner every day or even every week. The daytrader feels compelled to overtrade to justify his very daily presence before the quote machine. Many also perversely rationalize daytrading as a more conservative approach as they are not exposed to the risk inherent in holding a position overnight. This fear is bred by ignorance of the characteristics of price activity and the small probabilities for consistent gains over time actually make this strategy a high risk approach in the long run. The solution to this problem is to simply stop attempting to trade in the same arena as the professional scalpers unless you can somehow overcome the disadvantages mentioned herein. Meanwhile, study the characteristics of price action more and make an effort to change the time horizons of your trading activities. Can't Wait Syndrome Another harmful form of overtrading relative to time is the Can't Wait Syndrome which occurs both in market entry and exit. Here again, accumulation and distribution do not occur every day or even every week in a form which is practical for most to act upon from a vantage point away from the floor. Impatience normally reigns supreme, and in the case of premature entry, a trader is habitually entering the market too early, finding himself anxiously waiting for his position to comeback to even money and or getting stopped out too often. Pre-mature entry may be caused by an entry method which is too broadly defined. For example in the case of long entry, it urges you to go long sometime between the last throes of the previous downthrust and the beginnings of the next upmove. The end of a downmove to the beginning of a tradable upmove is normally separated by some type of accumulation or telling price action. If your entry method is too broadly defined, you will have too great a latitude in deciding when to enter. Thus you probably will gravitate toward entering just as soon as you get an inkling of a reason just to end the tension created by the pending decision or even worse because you miss the tension and enthrallment of being in a position, or you fear missing opportunity or you seek quick revenge from the last loss(es). None of the above are good reasons to enter the market. Being habitually too early by not waiting for a clear indication to take action you lose hope and patience while caught in consolidations. Because tops and bottoms normally exceed expectations you are often stopped out before the move begins in earnest. These pre-mature trades by their very nature increase your overhead while disturbing your composure. The solution to this problem is to of course first discover and examine your transactions to ascertain if this habit does in fact exist (If you are not already aware of it). The further treatment of this problem lies in the recognition and study of the time factor in changing the trend from down to up or up to down. Large interests and professionals act after accumulational/distribution or price action itself establishes a potential reward which is a multiple of the defined risk. This potential is in an energy yet to be released requiring time or definitive price action to store. Seek to focus your energies on timing your entry to be more in harmony with the beginning of an upmove rather than in the ending of the last downmove. Can't Stand Being Right Syndrome The "I can't stand being right syndrome" or premature exit is largely the same in character as premature entry. It is primarily manifested by the habit of entering a position then liquidating it as soon as it is slightly profitable. After getting out it seems that prices always seem to go higher (in the case of a long). This condition of premature exit is usually caused by the psychological need to take a profit to somewhat 4

5 relieve the trauma of recent losses; or because once one has entered the position the tension of making the exit decision is so great that you exit just to relive this condition of anxiety. Like premature entry the solution to the above problem is of course to first recognize whether the problem exists, then if so, to focus greater attention on overcoming your weaknesses and understanding the characteristics of trend activity. Realize that in order to maximize your profits you must end this habit of premature exiting. Study how you can more carefully define and fine tune the trend you attempted to trade so that you can stay with it to its culmination. In the attempt to optimize the distance between entry and exit, you must optimize your understanding of what occurs at each stage of price activity. From the end of a downmove, through a period of accumulation and trend reversal, into the stage of mark up in prices, through the distribution process, and trend reversal then full circle into the markdown in prices. As in correcting premature entry you must better qualify your rules for exiting to maximize profits. Overtrading Relative to Capital The second main area of overtrading is indulged in by probably 90% of all traders. The cardinal sin of overtrading relative to your capital is partially a child of the over-lenient margin terms which you are allowed to take advantage of (disadvantage may be more proper). In the attempt to understand the potential mental processes and realized actions of market participants, we must try to classify speculators into different species. We might attempt to explain market activities and our reactions to them according to the type of system or method one uses. Another way to classify participants might be segregation by the amount of capital they normally employ in their operations. We might divide participants into divisions based on equity. We could say that the participant in the smaller equity category is less capitalized and hence more vulnerable to panic during corrections and shake-outs and concomitantly assume those in the higher equity category are potentially strong holders of a stock or commodity. Overtrading relative to capital is best described by another method of division. That is the segregation of participants into varying degrees of capital risk per trade. It is this division which best groups traders psychologically, for these participants tend to act more closely in concert. On the left of the spectrum you have the participant who is habitually overleveraged. He is margined to the hilt and a sharp move on any given day against him requires liquidation or a shot of new margin money. He essentially is trying to maximize his leverage instead of minimizing his risk. His risk is 50% or higher sometimes. He is extremely nervous, can't sleep very well at night (no wonder!). When he is in a position he has a very difficult time making a rational decision. He is either right or blown out of the market all the time. He makes a large amount or loses big. He is drained at the end of the day and his decisions may be erratic and are usually not the result of good judgment because the risk attendant to his positions and capital are so great that he cannot maintain the presence of mind to think clearly. Risk Exposure Versus Rationality Moving to the right of the spectrum from this extreme you have lessor degrees of risk exposure per trade. As the risk exposure decreases the rationality of the participants increase. On the far right you have the participant which never is exposed to more than a 5% or so risk to capital. No single trade or even a series of losses are going to seriously wound him. He may be trading with $10,000 or $10 million but the % risk to his capital remains the same. The thousand dollar trader is in fact no different mentally than the million dollar trader. He is mentally akin as his low risk allows decision-making based on sound 5

6 judgment. He is not pressured to live or die by the daily fluctuations of the tape. He is interested only in net results over long periods of time. A professional interested in longevity can never risk no more than a small (10% or less) portion of his capital on any one venture. Firstly he knows his judgment falls apart when his capital is endangered by disproportionate risk and secondly if he is wrong (and his state of mind increases this probability) he will have a harder time recovering from his great setbacks or he may never recover. He is playing a game of survival and it is much harder to recover from a 30% or 50% loss than from a series of 15% losses. Prudence in the area of not overtrading relative to his capital insures his longevity. In this arena the small capitalized trader can trade with the same composure and presence of mind that a very large professional trades with. Dickson Watts, a renowned cotton speculator from the 19th century, stated that "The fundamental principle that lies at the base of all speculation is this: Act so as to keep the mind clear, its judgment trustworthy." It is upon this principle that all of your actions must be directed, and it is upon this principle that you should seek to avoid overtrading both relative to time and capital. Armed with the mental advantages aforementioned you have removed yourself from the masses of the crowd and are beginning to act rationally, decisively, professionally. 6