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Forex Trading Strategies – Respect The Table of Doom
Respect The Table of Doom
When we do presentations Kathy and I often pull out a chart that I dubbed the Table of Doom to demonstrate a key point of risk control. The Table of Doom is a devastatingly simple mathematical principle which clearly demonstrates that risks and returns in trading are highly asymmetrical.
In trading if you lose 25% you money you will need to make 33% on the remaining capital just to break even. If you lose 50% you will need to earn 100% and if you lose 75% you would have to quadruple your money just to get back to the starting point. Intellectually we all understand the numbers, but intuitively few of us have pay them the proper respect that they deserve.
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The Table of Doom was fresh on my mind this week when I read about Citadel Capital – one of the world’s biggest and most prestigious hedge funds. Citadel made a whopping 66% on its money over the past two years but has yet to break even because of disastrous losses in 2008 when it suffered a 55% decline. In an effort to retain clients Citadel was cutting fees this year in what Bloomberg dubbed “the worst climate for raising money in two decades.” More importantly, every trader at Citadel has worked for essentially nothing over the past two years as the fund tries to climb back to break even.
The Citadel experience opens up the question of just how much risk should one bear as a trader. One reasonable answer that I found comes from the latest book I am reading called Invisible Hands by Steven Drobny. Drobny interviews a variety of macro fund managers who were able to survive the 2008 crash in tact by using very strict risk control measures. One of the most popular chapters is an interview with Jim Leitner of Falcon Management who ran his own money after an illustrious career on Wall Street.
Since Leitner used only his own capital needless to say his respect for the Table of Doom was considerably greater than that of many of his peers. Leitner’s basic rule is that he will never allow losses exceed 10% in any given month and he will never allow his portfolio to drawdown by more than 20% in any given year. I found his reasoning to be quite interesting. Instead using a mathematical explanation for his risk control strategy he simply stated that 20% was his maximum psychological threshold for pain. Beyond that level he felt that he would lose control over his emotions and would be unable to successfully recoup his capital.
I found Leitner’s insight to be especially telling. How many times do we lose control of our senses as our losses mount? Past a certain point of drawdown we take on a fatalistic attitude and then grimly watch as our worst fears come true and our trading accounts withers to nothing in no small part due to our own reckless behavior. The irony of trading is that we should be open and flexible when it comes to analysis and highly disciplined when it comes to risk control. Instead we often become incredible dogmatic with respect to our strategies and highly profligate when it comes to risking our funds. Hopefully, the next time we trade we accord as much respect to the Table of Doom as Jim Leitner.