Since I went to cash the last week of January, I’ve been writing about staying out of the market until we get a dominant trend. I’ve forecasted whipsaw and did not believe I had any kind of edge to trade the market in its current state. I’ve speculated that the shorts that made money on the dip likely lost most of their profits when the market rallied earlier this month. While day traders might be able to scalp some profits in this market, longer term trend and swing traders are trading in conditions that are far from ideal.
My main point has been to convey that it is ok to stay out of the market for substantial periods of time. Money can be made very quickly. Last year I made all my profits from January-May. The rest of the year was a total waste of time. There is no reason I can’t have a great year over a 3-6 month period. Moreover, I’m in this for building longer term wealth so even if 2010 only brings single digit returns all is not lost.
One high profile trader that I follow is Tim Knight over at Slope of Hope. Tim runs a bearish blog and I enjoy reading his posts to get a bearish perspective on things and also because he is a talented writer. Today he has a post titled “Frequency Modulation.” In the post, Tim is honest and discusses the fact that he made some nice profits on the market’s move down in January only to see the profits evaporate when the market ran higher.
On January 19th, my portfolio had reached a nadir for the year (down about 2%). Over the next 13 trading sessions, little by little, I completely turned that around, and by February 5th, my portfolio was at a new high. I felt fantastic, and I had just had the biggest cash gain intraday of my entire life.
In the subsequent nine sessions, by February 19th, I was right back to where I was before. From the 19th to the 19th, I had come full circle.
While Tim is just one example, it does illustrate my point that playing every little move is usually not worth it and that at least one well known short trader did not make any money during this brief correction. Tim is a skilled trader and the only thing the whipsaw took from Tim was his time. However, I suspect that many less experienced traders might have walked away from the whipsaw with a loss.
I really believe that “less is more” often applies to trading.
Imagine if your system was as simple as being long during bull markets and staying out of the market during downturns.
Learning how not to lose is so much more important than winning big. I see so many other traders out there touting huge returns over short periods of time. Here is an example of why I am wary when big returns come so fast. Imagine a hypothetical $100,000 portfolio and assume the risk free interest rate remains at 0%. The risk free rate is important because if treasuries were yielding 15% a 12% return is a bad year. If treasuries are yielding 0%, it is a good year (by most standards).
Trader A uses highly leveraged strategies such as options, futures and 3x ETFs to magnify returns.
TRADER A
| Year | Beginning Balance | Return | Ending Balance |
| 2010 | $100,000 | 40% | $ 140,000.00 |
| 2011 | $ 140,000.00 | 40% | $ 196,000.00 |
| 2012 | $ 196,000.00 | -48% | $ 101,920.00 |
| 2013 | $ 101,920.00 | 75% | $ 178,360.00 |
| 2014 | $ 178,360.00 | -40% | $ 107,016.00 |
| 2015 | $ 107,016.00 | 25% | $ 133,770.00 |
| 2016 | $ 133,770.00 | -25% | $ 100,327.50 |
| 2017 | $ 100,327.50 | 30% | $ 130,425.75 |
| 2018 | $ 130,425.75 | -20% | $ 104,340.60 |
Trader B trades stocks and ETFs. Trader B certainly has to take on substantial risk to earn double digit returns but generally doesn’t use leverage. In rare instances, Trader B might use leverage if market volatility is extremely low (e.g, a VIX in the single digits). Trader B would never use leverage when the VIX is north of 30.
TRADER B
| Year | Beginning Balance | Return | Ending Balance |
| 2010 | $100,000 | 15% | $ 115,000.00 |
| 2011 | $ 115,000.00 | 21% | $ 139,150.00 |
| 2012 | $ 139,150.00 | -8% | $ 128,018.00 |
| 2013 | $ 128,018.00 | 12% | $ 143,380.16 |
| 2014 | $ 143,380.16 | 7% | $ 153,416.77 |
| 2015 | $ 153,416.77 | 18% | $ 181,031.79 |
| 2016 | $ 181,031.79 | -6% | $ 170,169.88 |
| 2017 | $ 170,169.88 | 17% | $ 199,098.76 |
| 2018 | $ 199,098.76 | 11% | $ 220,999.63 |
Obviously everyone would rather be Trader B with the $220,999.63 than Trader A with $104,340.60. Trader B wasn’t perfect. 2012 and 2016 were both down years. There was also only 1 year above 20%. However, Trader B generally managed not to lose money. Meanwhile, Trader A earned 40% in 2010 and 2011 only to lose all profits at the end of 2012. 2013 was fantastic for Trader A. A whopping 75% return. Unfortunately, the –40% return in 2014 pretty much wiped out Trader A’s huge year in 2013.
My two points are first that simply not losing is a big part of winning. One big drawdown will take away years of winning. Second, traders should be wary of those touting huge gains over short periods of time. Keep a longer term view of things.
The following scenario is Trader A’s thinking from 2010-2014:
You are Trader A and are following a trader online for 6-9 months. You become impressed with the huge gains the trader has made over such a short time (the trader has verified their success by posting their account on covestor or similar service and you are confident it is not a scam). Lucky for you, the trader has a subscription service permitting you to follow their trades in real time. You signup and feel you are the luckiest man/woman in the world. After all, you are Trader A and just made a 40% return in 2010. In 2011, you secretly wonder if 2010 was just a fluke and whether the trader you are following just had a hot hand or the right strategy at the right time. But as 2011 precedes on, you not only feel more confident about the trader you are following, but you have bought into the trading style yourself. Y
ou are even passing on the gospel to other traders on the Internet and to your friends in real life. After all, 2011 ends and you are up another 40%. Your $100,000 portfolio has doubled in 2 years. You’re actually thinking about quitting your day job because your trading profits are now a substantial portion of your income!
2012 comes and things are not going so hot. Your account starts to dip but you understand that you can’t make money all the time. You’ve got your trusted system and the plan is to simply keep trading through it. Wow, you were not expecting this kind of cold streak. It seems like every trade is going against you. 2012 ends with a whopping –48% loss erasing all of the profits earned in 2010 and 2011.
You figure that you only lost profits and still have your principal and that you’ll see how 2013 goes. You knew you were a great trader! Wow, a good thing you didn’t quit in 2013. Your trading account becomes a money printing machine and you earn a return of 75%. Here comes 2014. You guessed it, a 40% drop wipes out most of your profits again. You suddenly feel that trading is eerily similar to playing craps in Las Vegas. The euphoria followed by the huge let down.
You are basically back where you started in 2010. You have about $7,000 in apparent profit although most of that money went to pay for subscription services. You have put in a lot of time and had a wild ride, but really don’t have anything to show for it. Moreover, if you simply put your money in a risk-free CD you would have made more money without any of the risk.
Even worse, your friend Trader B, that you often scoffed at as an “old school” trader, is now having the last laugh. Trader B has $45,000 in profits more than you and is also in much better physical shape. After all, Trader B wasn’t screaming at the computer screen during huge drawdowns and having sleepless nights.
I’m not saying that every trader earning huge returns is Trader A. What I am saying is that anyone earning these kind of returns should take a long and hard look to see if they might be Trader A. In terms of statistical probability, there is likely a very small group out there earning hyper returns over a long period of time without performance killing drawdowns (think Steven Cohen, although he likely has a certain edge that most retail and institutional traders don’t have access to). Maybe the subscription service you are subscribing to falls into that group. Maybe your trading system falls into that group. Anything is possible.
But the one thing that is an absolute fact is that almost all of these hyper- return portfolios you hear about on the Internet are Trader A (in fact, Trader A didn’t even claim returns of over 100% and managed to at least not lose money – many out there are actually much worse than Trader A). There simply are not that many Steven Cohens out there. So if you do see claims of hyper-returns, ask yourself whether you believe that the trader you are following is Steven Cohen or Trader A? Of course, the trader claiming the returns may not even be a good as Trader A. There is also Trader C out there. Trader C trades like a gambler in Vegas. This kind of trader earns a 100% return in 2010 but then suffers a 70% drawdown in 2011. At the end of 2011, Trader C would have lost 40% of their principal (a $100,000 account would be down to $60,000).