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Pedal To the Metal
Last week I posted a Twitpic of New York city bus poster that had two pictures of the same face. On one side the face was completely battered on the other it was perfectly preserved. The tag line read, “Hit at 40 mph, Hit at 30 mph” emphasizing the point of adhering to the speed limit in New York city. The ad was stark and very effective communicating succinctly the danger of pressing your luck.
At its core the New York city bus ad was all about tipping points. Press on the gas pedal just a bit more and the result can be the difference between life and death. For me this was perfect metaphor for trading. Most traders never consider tipping points. A small hedge on your loan book can quickly transform into a massive 3.5 Billion dollar loss as JP Morgan found out last week. Even the best traders in the world never fully appreciate the deadly combination of adding to a highly levered position in an unfavorable market environment. US mere mortals in FX land make that mistake all the time.
I think the reason that most traders fall into this trap is because we mistake geometric for exponential progression. In other words we think that any additional unit of risk will simply result in one additional unit of loss when in fact the losses compound almost exponentially as they propagate not only through the new position but through the entire inventory on the books. This was the mistake of the “London Whale”, Nik Leeson, Long Term Capital and many future traders still to come.
In a recent interview with Marc Sidwell, the business editor of City AM he asked me, “What is the worst mistake a trader can make?” To which I instantly answered, “Average down into a losing trade.” It is ironic that I would say that since I am notorious for doing just that in my “junk” trading account. In fact if you look at the trade runs in that account over the past several years the story looks depressingly similar, nice runs up followed by a few swift declines that wipe out most of the equity. Essentially the account looks like a mini version of LTCM.
Until December 8th of last year. That was the final time I averaged down in my “junk” trading account. Lo and behold equity never dipped more than -2% since that time and now stands 10% higher. That’s hardly gangbuster returns, but remember I do a tremendous amount of experimental trades in that account so it’s a miracle that it up even by that much. What’s absolutely incredible is that the “junk” account trade results are testament to that New York city bus ad. Lay off the gas and you’ll stay alive in New York city traffic as well as in your FX trading account.