Trading Rule – “Never trade positions larger than you can afford”

IF YOU LOOK AT THE HISTORY OF TRADING DISASTERS IN THE WORLD, ONE COMMON THING YOU WILL COME ACROSS IS THE PROPENSITY TO TRADE MUCH BEYOND THE RISK THAT THEY COULD TAKE ON. TAKE THE CASE OF THE BARINGS IN 1995 OR MORE RECENTLY IN THE CASE OF MAN OF UK. IN THE CASE OF BARINGS, NICK LEESON HAD SOLD STRANGLES ON THE NIKKEI INDEX TO AN EXTENT HE DID NOT HAVE THE CAPITAL TO SUPPORT THE TRADE. THE DISASTER WAS COMPOUNDED BY SOME REALLY LAX BACK OFFICE DISCIPLINE AT BARINGS. THE NET RESULT OF TAKING POSITIONS BEYOND WHAT THEY COULD AFFORD WAS THAT BARINGS SAW ITS ENTIRE CAPITAL BEING WIPED OUT

WHAT IS THE LESSON FROM BARINGS DEBACLE?

The story of Barings highlights two of the fundamental errors of trading viz. unfettered risk taking and very weak risk management systems. Nick Leeson who was trading Asia out of their Singapore office had sold straddles on the Nikkei expecting the Nikkei to be in a range. The idea was that the Nikkei would expire worthless and the entire premium would be their income. The only problem was that Leeson had been manipulating the books by showing the premium income as earnings and reducing the margin requirement. To hide the margin requirement Leeson started to write strangles more aggressively and more at the money strangles. Unfortunately, disaster struck when there was a Kobe earthquake and the Nikkei crashed the next day. The full extent of the losses became clear only when the margin call was made and Barings defaulted leading to its entire capital being wiped. The big lesson is to not trade what you cannot afford

RISKS OF TRADING MORE THAN YOU CAN AFFORD…

What we saw at a very large level in the case of Barings is visible in a much smaller way to all traders. Remember, that every trader trades with finite capital and hence capital protection becomes the primary focus of every trader. You obviously cannot protect your capital if you recklessly take positions in the market. For example, if you are trading futures in the market then taking 5-7 times leverage with tight stop losses is understandable. However, if you leverage to the tune of nearly 20 times then you are running a huge risk that you cannot afford. Even a 2% movement can have almost impaired half of your total capital available for trading. Things can get worse in trading if you are also going to add overnight risk to your trading portfolio. When you carry forward positions to the next then there are lots of developments in the US, European and Asian markets that could make the trade go against you. In fact, if you are adding overnight risk to your trading portfolio then you need to get a lot tighter in your risk management. Limit the risk that you take on your positions.

“Trading more aggressively than you need to do and putting greater strain on your trading capital are the two cardinal sins”

5 WAYS TO KEEP YOU’RE TRADING POSITIONS IN CHECK…

1. Even at the risk of repetition it needs to be reiterated that stop losses are a must for every trade. Not just as an afterthought, but stop losses must be part of your order on the trading screen. Period.
2. Another more sophisticated method is to keep limits on losses on a daily basis. This can vary based on the size of your capital and how much you can afford to take, but it is the discipline that is important. For example, on a trading capital of Rs.5 lakh, you have a 5% limit of losing maximum of Rs.25,000 in a single day. At that point, you, must have the discipline to shut down your trading terminal and stop trading for the rest of the day.
3. The third discipline pertains to how much capital you are willing to lose. This is important because every trader starts off with finite capital. It does not matter whether the trader is a small trader, Stanley Druckenmiller or George Soros. Capital is finite, though the quantum may differ. The focus must be on deciding at what point of capital loss you will get back to the drawing board and rethink your strategy.
4. Always impute a cost of capital into your trading account. If you keep idle money in your trading cost, it has an opportunity. At least it can earn 7% in a liquid fund. Take that as your opportunity cost and keep that in your calculations when you calculate your capital risk. Your situation becomes a lot clearer.
5. Base your risk on the profit you make. For example, once you have made profits on your trade, you can classify that into core capital and earned profits. You can take a higher risk on earned profits and lower risk on core capital. This will ensure a more even and rational distribution of risk.

THERE ARE MAJOR RISKS IN TAKING UNWIELDY POSITIONS…

Most of us look at the risk of unwieldy positions in terms of the potential loss. But that is not all. When you take unwieldy positions you are losing out on many smaller opportunities that go waste because you do not have the capital or the appetite to take on that risk. Also it detracts your attention from your core focus of trading, which is to be profitable.