And, there's no better place to put your emotional state to the test than in the futures market (OK, options can have nearly the same effect).
First there's greed. Greed talks to you. It says, "this market is going up, and you need money, and if you just add another couple of contracts things will be great." After all, you've been making money lately. Your system is working again. The market is behaving exactly as you had predicted. So, you add another contract to an already overleveraged position. You can't help it. Your hand just picks up the phone and makes the call.
Or, you aren't making enough money so you really want to try to sell some option strangles, or buy some soybean calls, or short the Yen. You convince yourself that you need to diversify more, so you pick up the phone and make the trade.
Making money doing this can be the worst thing that can happen to you because you start to get used to being overleveraged, overexposed, unsure of your real risk.
Then one day everything goes wrong. You're watching the screen, or CNBC, or CNN and some government report comes out, or Alan Greenspan says something utterly confusing, or the Japanese Prime Minister says something about the Yen versus the Dollar. Then, BOOM. Everything goes nuts. If you have stops in place they're hit and immediately the market reverses. If you don't have stops in place the market just keeps moving against you. ALL your positions tank at once. This wasn't supposed to happen.
Greed now turns into fear. Your system says to wait until the close then make a calm, rational decision overnight. But, it's Friday, and how are you going to sleep over the weekend if you don't do something NOW? What if the selloff (or rally) continues into the close? You try to estimate the damage - depression sets in, then fear.
Fear works quite the opposite from greed. Greed speaks to you and makes you take on a series of trades one by one that gradually place you in jeopardy. Positions taken on because of greed are often done with careful consideration over time - days or weeks. But once fear sets in you feel a tremendous passion to just bail out of whatever it is that's making you crazy. It's a one decision, "get me out", "take away the pain", and "I want to be safe" kind of feeling. So, you pick up the phone and bail.
Often, actually usually, the market comes back after you bail. This is because you bail at the point of maximum fear, and that's also the point of maximum fear for everyone else out there who is losing money - so you all bail at about the same time. And, that means the market is going to reverse.
How can you avoid being taken in by these two emotions? The only cure for greed seems to be repeated losses. If you get burned often enough you'll learn to be careful.
The only answer I have for fear is to keep your leverage conservative. That way even the worst losses aren't going to kick you over into fear mode and make you do something you'll later regret.
So, you MUST understand leverage. Here's a simple way to calculate leverage. Let's say the S&P500 futures contract is trading at 950. Multiply that by $500 and you get $475,000. If you want 2:1 leverage you need $237,500 in your account for each contract that you trade. The exchange minimum margin is about $16,000. That's 30:1 leverage. Let's say you use exchange margin as you guide. You are trading a $50,000 account. You are long 3 S&P contracts and the market drops limit down (-15 points). This means you will be down 15 points x 3 contracts x $500, or $22,500. You have just lost 45% of your account value in 10 minutes! Fun isn't it?
Now, what are you going to do? Your system is calculated after the close. Can you wait? What if it's too late and your stop was just hit? What if you just went short, the market comes off limit and starts to rally? You just lost 15 points and you are now short, and you are starting to lose more on the way up. So, fear sets in and you pick up the phone and BAIL. You are out. It's over. Can't cry over spilt milk. Better to be safe than sorry. You lived to play another day. It could have been worse. You're still in the game.
Do you really want to live like this? How can you keep in control? You have to assume that major whipsaws will happen. And you have to assume they WILL happen to YOU. And when they do happen, how much will you lose? If you can keep the losses on the REALLY bad days to 5% you're lucky. That way you'll have enough leverage to make money when things are going well. You have to be able to survive the wars in order to enjoy the peace. You must have enough chips left to stay in the game. You must not be in so much emotional pain that you quit playing, or trading.
If you can survive the losses, you have a chance of making money. And, hopefully, you will learn from your losses. If you do, you will get better at trading over time.
So, my first rule of market survival is to keep leverage conservative. I don't recommend more than 3:1 leverage. I can handle that. You may be able to handle more or less, depending on your situation or circumstances. But you must know your leverage position and don't be fooled by margin.
One last note about leverage as it applies to options - at least if you're long options you always know your maximum potential loss. That way you can preplan for the bad days - you can assume the worst and you will know how much you may lose if that happens. If the market moves against you and your options drop to near zero value, you have nothing to lose by just holding on. The market often comes back. In the futures market once your stop is hit you're out. If the market comes back you're still out.
Sounds good, but since most options expire worthless it's obvious that few investors/traders are doing their homework. Do your homework. Know the leverage of all your positions. Calculate the potential loss if they all tank at once. One day they will.
---Tom Loffman
Copyright, 1997
Tom Loffman, Equity Systems