By: Chris Rowe — December 20, 2018
This past Saturday, I sent you three trading rules you need to live by.
Some folks wrote in asking me to say more about those rules. (As always, thanks for your great feedback. Nothing lets me up my game like comments from my readers.)
So today we're going to drill deeper into Rule #1... the single most important rule you'll ever follow. Stay true to this rule, and your account will thank you.
Here are the two most powerful words you'll ever read about investing:
The smartest traders and investors on earth sometimes get killed because they can't follow this one simple rule. That's because sticking to this rule is much harder than learning to understand how to analyze markets, sectors, or stocks.
Think back to the end of the last decade...
Remember a fellow named John Corzine? From MF Global Holdings? He was one of the smartest and most sophisticated investors on earth. Yet he overleveraged himself and it sank his entire firm. Do you think you are a better trader than he is?
As simple as this critical principle sounds, it can be the most difficult to follow because (as we pointed out last week), instead of dealing with analysis and logic, it deals with the never ending fight against our own human nature.
IMAGINE STARTING WITH $50,000 IN CASH
Say there's a stock we're interested in trading. We decide to use a "stock replacement strategy" by trading call options instead of trading the actual stock.
This strategy involves "leverage" -- a word that some people find scary. But here's what too many people don't know...
If used properly, leverage involves a fraction of the risk we'd take by trading a stock or ETF. And it offers a much larger potential reward.
Let's walk through a couple of examples.
First, understand that "notional value" is the total value of a leveraged position's assets. Typically, a single call option represents 100 shares of stock. So if we own one call option that gives us the right to buy, say, an $80 stock...
Then the "notional value" here is $8,000. (100 shares of an $80 stock = $8,000.)
Thus, what we've done is used $900 to control $8,000 worth of stock.
If the stock price is cut in half, the stock owner loses $4,000. But the call option owner loses just $900. That's the benefit of using leverage the RIGHT way.
Of course, there's another side to this...
When you are overcome with greed or you feel, as most of us do from time to time, that your current lifestyle is unsatisfactory, it can be tempting to use the power of leverage to control a huge position.
Starting with $50,000 you can use leverage to control $500,000 worth of stock (a BAD idea)...
Or, (as we just saw) you could control $50,000 worth of stock by only putting $5,000 to work and only risking $5,000 (a very GOOD idea).
A PICTURE WORTH A THOUSAND WORDS AND A MILLION DOLLARS
The table below spells out a set of six hypothetical scenarios for this kind of trade. Notice that the trades represent different notional values (the first column).
We started by trading positions with a notional value of $10,000. Depending on the specific cost of the particular option, we might have committed $900 to the trade, or we might have committed $1,100 to the trade. In any case, in each of the first three trades, we control $10,000 worth of stock.
In the third trade from the top, we made an 80% return on the position. That caused our account value to spike 16%, which is actually a nice annual return for the average investor.But in the fourth trade, we were feeling overly confident (that is, overly emotional) about a trade. Plus, maybe we felt that because we made a nice profit on trade #3, that we could afford to risk a little more. So we find a very volatile stock that just took a huge dive lower. We felt that this stock would climb much higher just on a "dead cat bounce".
So we used the power of leverage to control a much larger position (in terms of notional value). We used $16,000 in cash, but we used it to control a position with a notional value of $80,000.
But the stock fell further and we lost $15,000. The prior stock advanced 80%, but the overleveraged stock only lost 18.75%. In dollar terms, you lost nearly twice as much as you gained on the prior trade!
As you can see above, your account value went from being up 16% to being down 14%.
That may not seem like a big deal. In fact, we felt like we should reduce the notional value position size to $20,000 for the next couple of trades. It's twice the amount we originally intended to trade, but now we feel like we have to step up the trade size so we can make back our money.
Instead of turning this into a "slasher movie", let's assume that over the course of the next two trades we made 20%, and then lost 10%. By the time the "smoke clears away," (the bottom entry in the last column, far right) our account is down 10% overall.
And you and I both know the story can have a much worse ending than that. That's the danger of overleverage.
Now let's look at a slightly different version of the same table, below. Here we have the same exact percentage returns on each trade (the fourth column), but with an investment of $10,000 notional value put into each trade (first column).
As you can see, instead of having an account that is down 10%, you have an account that is up 14.25%. I could have spiced up the story with more volatility and compared an account losing 76% to an account going up 34.25%, but I don't even want you THINKING in those do or die terms. Let's think about this realistically.
Also note that this is a VERY oversimplified hypothetical scenario. I don't think it makes sense to invest one "typical" amount of money into positions (such as the $10,000 in the scenario above). It makes sense, instead, to first decide how much you are willing to risk on a trade and then go from there. But that's another lesson for another day.
As we said on Saturday, You can have the most successful system on earth, showing winner after winner...
But overleveraging on just one single position renders that system null and void. That is. it's no longer a system. It can open up a whole can of worms and cause a domino effect that can easily spiral out of control, where you’ll find yourself spending the next several trades trying to make your money back from one careless loss.
Be a disciplined trader. Follow a smart trading philosophy. The rest will fall into place!
See you soon!