How to Blow up your Trading Account – 2/24/13

After hearing how a friend of mine lost a large part of his trading account last week, I felt down. How do you blow up a trading account? By studying that, we can consider the opposite side and protect ourselves from such a catastrophe.

The market has no heart and does not care for you or your problems. If your trading system is trend following and generates 45% winning trades, with a 1.75:1 win to loss then a random Monte Carlo simulation will show that we will have 5 losing trades in a row soon enough. The lower the win %, the more frequently we have higher consecutive losing trades. Now if I traded a large part of my account and each loss was 20% of my account, I would not have much of an account left after 5 losing trades. Therefore I have to contain my loss to no more than 2% of my account. This may be a very small amount of money and unfortunately most people starting off with small accounts cannot follow this 2% rule. Consequently when bad times hit, they see a huge dent in their account. Under capitalization, or poor money management as we would call this, is the primary reason why accounts blow up. The desire for fast money in an under capitalized account is the primary culprit.

What if the trader is incredibly good and seems to have a very high win % like 75%? The market says that chances are your few losses are going to be huge. Your Win: Loss ratio could be 0.20:1. This means your system is going to generate lots of small winners, giving you good feelings till the huge loss comes by and knocks you out periodically. And again, if you think you have many winners in a row, it could give you over confidence and a large loss could easily become even larger if you “hope” that it will turn around in your direction and add to losing positions. More about that next.

Perhaps the quickest way to blow up you account is a method I have perfected using paper money trading accounts! I see a trend up and start trading against the trend expecting it to mean revert. As it goes against me further, I add positions against the trend. Soon I blow away my money management rules and have a much larger position than I ever planned to. Worse would be to double up on positions. The market remains in the trend irrationally longer than my account can handle and pretty soon there would be margin calls and trades automatically closed by the brokerage house due to insufficient funds in the account. I have done this repeatedly with paper money in day trading I will admit; and learned never to do this with real money.

The lesson learned that I must execute one day, and this is the real secret to making big money, is to do the opposite. Start with a modest position but as the long trend continues, add to positions on a dip in the direction of the trend and take some small profits along the way as it hits minor peaks. Pristine promotes this method also. If it is huge long trend, at the end of the trade you will be very happy with the profits in your account. If it is a small trend then any losses or profits would be small.

- Remember if we do the opposite, then we will certainly blow up our account at one point or other…

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So here are the key steps to blow up your account:

1. No stop losses
2. Technical trading combined with hope and pray that it follows Fibonacci or other reversal levels
3. Trading too large positions for the size of the account – poor money management
4. Betting against the primary trend and adding to positions as it goes against you
5. Letting emotion get the better of you and not taking the small loss
6. No diversification or hedge

I hope we will always do the opposite.