Adam Hamilton December 31, 2004 3663 Words
Speculation is truly a strange art. It is one of the few undertakings in life that has virtually no external limits. In most undertakings, outside rules are imposed on participants to protect them. But speculation, betting on future price movements, truly takes place in a limitless environment.
If you choose to be a speculator, you are free to do whatever you want with your capital. There are effectively zero exogenous limits to guide your behavior. You can bet any amount on any potential market movement at any time you wish, period.
For example, via options you can bet everything you own on the direction of a trade expiring in a few weeks, with a 10x gain if you are right and a 100% loss if you are wrong. If you employ specialized trading tools like derivatives or debt leveraging, you can even bet more capital than you control. The markets allow you to follow any course of action that you see fit, sans judgment.
Limitless environments are glorious dreams for those who are psychologically prepared, but for those who are not they can be exceedingly deadly. It is hard for most people to understand how to protect themselves in a limitless environment, since they are so foreign to all of our normal life experiences outside the markets. In real life, from the moment we are born until the time we die rules exist to protect us from ourselves and others.
For example, when we drive our cars we are subject to speed limits. Even if you loathe government meddling in life as much as I do, you will probably agree with me that some level of speed limits is probably prudent on most roads. In addition to keeping traffic flowing smoothly, the speed limits protect us from ourselves, other drivers, and factors completely outside of our control.
My only personal experience with limitless driving occurred in Montana a decade ago. Montana is a huge beautiful state with awesome interstate highways, many stretches arrow straight for miles on end. In the mid-1990s Montana abolished its set speed limit on controlled-access interstate highways, instead merely decreeing that drivers self-limit themselves to a ďreasonable and prudentĒ speed. After a while they reinstated the 75mph limits, but the no-limit period was very interesting.
At the time I was driving a Porsche, and it was initially great fun to streak through Montana. I passed highway patrol officers doing 90mph and they never gave me a second look. On particularly gorgeous sunny days with very low traffic, I would sometimes run over 100mph. It was fun, an adrenaline rush, but limitless driving, just like limitless speculation, is very risky.
If I had hit one of Montanaís gazillions of deer grazing along the highways at 100mph+ in a little car, I would have been killed instantly. If one of my tires had blown, I probably would have died in a fiery crash as well. Regardless of how good any driver may be, the truth of the physics is the faster one drives the more ground he covers before he can react and the more catastrophic any unforeseen event could prove to be.
And it is always the unforeseen events that are the most dangerous for speculators, the market equivalent of a deer suddenly darting onto the road from nowhere or a catastrophic mechanical failure. The fewer limits you set on yourself in the markets, the higher the probability that an unforeseen event will totally wipe you out sooner or later. Countless speculators ďblow upĒ, or lose it all, after taking far too great of risks and then seeing their trades move the wrong way.
In order to survive speculating in a limitless environment, you have to set your own internal limits. Speculators can get lucky for a season, just like a super fast driver, and not encounter an unforeseen event for a long time. But sooner or later the laws of probability inevitably catch up with aggressive speculators and drivers. If your speculations are aggressive enough so one or two catastrophic trades can potentially break you, then you are not going to last very long in this exhilarating yet unforgiving game.
This week I would like to discuss tactics that speculators can use to survive and thrive in a limitless environment. The markets could not care less whether you or I win in the end or go bankrupt speculating, so you have to actively and continuously protect your own capital. You can approach speculating in such a way that not even multiple adverse unforeseen events can threaten your ability to stay in the game.
The wrong way to speculate is the way most new speculators start out. They come to the markets starry-eyed, convinced that they are good enough to wrest away huge gain after huge gain with their trades. They know way back in some dark corner of their minds that the markets are risky in general, but they are so confident that their own egos override prudence.
They start by making an initial trade. Then, as they watch this trade, they become convinced that they should bet even more on their great idea. So whether this first trade is up or down, they layer in the rest of their capital and sooner or later are fully deployed in one play. They dream of a perfect world where the best-case scenario happens and think of how they will spend the wealth that is certainly coming to them.
But, more often than not, something unforeseeable transpires. A whole market can crash like the NASDAQ, a promising single company can implode like Enron, or one of a whole broad array of other adverse events can happen out of the blue. The new speculator is fully deployed in one trade and the markets move against him. Soon his capital dwindles and his stress escalates exponentially. Odds are his psychological investment in his one big trade is so high that he will stubbornly ride it to the very bottom and be wiped out.
In order to ensure that this common speculation hazard doesnít crush you, there are crucial steps to take so you not only survive but thrive as a speculator. They involve emotional steeling, position-limited portfolio construction, mechanical profit and loss management, and a carefully cultivated understanding of the true random nature of the tactical markets.
On the emotional front, never grow attached to any single trade. Admit to yourself right away up front, before you commit capital, that even though a particular idea sounds good you are but a mere mortal who cannot see the future. No matter how much due diligence you do, no matter how sound your logic, no matter how sincere your effort to make a great trade, there are always events outside of your control that can obliterate the best of plans and intentions. Expect the unexpected.
New speculators really donít like to lose, so they become emotionally attached to their trades. They feel as if it is them against the markets, and they think the markets will be forced to see the wisdom in their position eventually. Thus they become married to a trade and will ride it down to zero if the markets take it there. You have to emotionally steel yourself so you never grow overly attached to any one trade.
Since speculation is totally dependent on incomplete information and an unknown future, not every trade is going to win. By refusing to get emotionally involved with any of your trades, you can objectively cut your losses early before they get out of hand. You have to let your winners run and cut your losses, exactly the opposite behavior that new speculators instinctively follow when they nervously sell for small profits while confidently letting their losses balloon because they know they are right.
Losing trades are normal and expected for speculators. Just like buying food is a normal cost of business for a restaurant owner, for a speculator losing trades are a normal cost of business for this game. Not every trade will be a winner, so losses must be accepted without emotion. After all, you can make a great trade and still lose money simply because some unforeseen event moved your speculation in the wrong direction.
Donít fall into the deadly trap of believing that being right all the time is a critical component of your self image. There is no dishonor at all in being wrong now and then. And when you are trying to predict the future, being wrong is inevitable. There is no way around it. So when you lose just shrug, learn a lesson from the markets, and move on.
After acknowledging that you cannot know the future before it happens as well as actively forgoing getting emotionally involved with your trading decisions, you need to limit risk. Controlling risk, like putting on a seat belt, is done before you even make a trade, not once you are in it. If you wait until you are actually deployed into a trade to manage risk, then you have already lost the battle and are going to get obliterated by an unforeseen event sooner or later.
To limit risk before entering a trade, you have to set position limits and stick to them come hell or high water. First, divide your total liquid capital up between long-term investment and short-term speculation. Capital very important to your emotional well being, such as retirement funds, college tuition, house down payments, etc., should never be used for speculation. Never! Never speculate with capital that you cannot afford to lose without shedding a tear.
Once you have capital set aside for speculation, divide that speculative portion up evenly. Ecclesiastes talks of 7 or 8 way capital splits, and I personally use 10 in my own speculating. If you use a 10-way split for your speculative capital pool, then your position limit is always 1/10th of your total speculative capital. Never ever, for any reason, put more than a tenth of your speculative funds in any single trade. Position limits protect you from unforeseeable events.
If you limit yourself to 10% of your speculative portfolio risked in one trade, then even a catastrophic 100% failure in that particular trade wonít hurt you terribly. If a rookie speculator violates this wise rule and puts most of his capital in one great idea for a trade, he risks blowing up and being blasted out of the game if it is a total loss. But position limits ensure that a catastrophic unforeseen event in any one trade, a deer on the highway, wonít destroy your portfolio or ability to trade.
Now just because you prudently set position limits doesnít mean you have to always deploy a maximum position right away in a new trade. If you want to first test the waters, you can allocate 2% of your capital to a new trade instead of 10% right away. If this initial 2% proves profitable, if the markets prove you right, you can then layer in and pyramid on greater quantities of your winning trade, up to your 10% limit of course.
Adding to a winner up to your position limit can be a good strategy to limit risk early on in a trade, when information is sparse. And if you are losing on an initial exploratory 2% trade, then you can easily admit that you were wrong and refuse to chase bad capital with good.
And if you are running hyper-risky trades such as options, you should farther subdivide up your position limits. Because options are certain to expire in six months or so, they are vastly more risky than conventional stock trades. As such, you might want to take one or more of your 10% position limits and subdivide them further for options. Rather than having one options trade taking up a single 10% position, you can have five separate options trades equally allocated to that single 10% compartment at 2% of total speculative capital each.
However you decide to do it, you need to ensure that you use position limits to minimize your risk up front, before you even make the trade. Position limits help keep you emotionally detached by preventing you from falling too in love with a trade as well as protecting you from the unforeseeable events. Position limits are one of the best portfolio management tools to utilize in a limitless speculation environment.
While most of the risk management for speculation is done before a trade is even made, risk still needs to be managed once a trade is deployed. In order to avoid making the devastating rookie mistake of capping wins and letting losses run, a speculator needs some type of mechanical non-emotional system for sells. This keeps them in winning trades as long as possible while at the same time getting them out of losing trades as soon as possible.
The best mechanical selling system I have ever used is also one of the simplest, trailing stop losses. A trailing stop loss is simply an open order to sell whenever a price manages to fall more than a certain percentage behind its highest price reached since you launched the trade. I typically use 20% trailing stops in my own stock trades, although I do tighten or widen these stops occasionally under certain situations.
When speculating, buying is always the easiest part. Before you buy, you are out of a trade and emotionally neutral. In addition, all kinds of technical tools can be used to define high-probability-for-success moments to buy. Selling, however, is always the hardest part of speculating. In normal long trades you can only sell after your capital is already at risk, sucking you in emotionally.
This greatly magnifies the danger of succumbing to greed and fear, the greatest internal enemies of every speculator that dwell deep in all of our own human hearts. Greed mucks up sell decisions in a couple primary ways. If you have a stock that has risen significantly but then started correcting, greed may prompt you to stay in and ride it to the bottom like a NASDAQ investor. After all, it has to recover right?
Greed flares up again when a stock you own has fallen significantly. Rather than cutting your loss and admitting that you were wrong with your bad trade it is so tempting to stay in a losing position and hope it returns to break even so you can sell. Greed clouds selling decisions, but so does its sister emotion of fear. Fear is a much more visceral and urgent emotion than greed so it is probably even more dangerous to a speculator.
Fear leads to bad sells in a couple primary ways too. When you have a small profit in a trade, it is easy to get fearful that you will lose the profit if you donít lock it in. Yes, you may never go broke taking a profit, but similarly you will never grow wealthy if you donít let your profits run. Fear also cripples sound selling judgment when a sharp single-day move terrifies you into selling. Selling should never be emotionally based, period.
In order to let your profits run as long as possible and cut your losses as soon as possible, you have to totally eliminate greed and fear from selling decisions. Mechanical trailing stops accomplish this automatically, leaving you in winning positions until the last possible moment as well as ejecting you out of losing positions early before they can do any serious damage to your overall speculative portfolio.
With a 20% trailing stop in place on your positions, an open sell order is automatically set 20% behind the best price achieved on your trades to date, or 80% of your trade-to-date high. You donít even think about selling because the mechanical stop rule of selling as soon as the 20% retreat is violated happens automatically. Once you are stopped out for any reason, you can much more easily be emotionally neutral again while your capital is safe on the sidelines and decide on your next course of action.
Trailing stops let winnings run because they arenít worried about locking in a small profit. As long as a trade doesnít pull back 20%, then you stay deployed and let your wins multiply over time. With a trailing stop deployed, you can quit worrying about profits and just calmly ride your trades. The anxiety of the sell decision is totally removed since a simple mechanical rule will make it for you. Your wins will run unimpeded until they pull back 20%, then you will automatically realize your profits.
Trailing stops cut losses because they donít get emotional about waiting to break even to sell. If buy a trade and it falls 20% from its highest point to a loss for you, then the sell automatically executes. You may have been right on the trade, but you were wrong on timing and it is best to be out of the trade and emotionally neutral so you can reconnoiter. Losses have no time to balloon out of control when they are automatically realized at a mechanical point.
In general, 20% trailing stops mean that you will seldom lose more than 20% of one position, or 2% of your total speculative portfolio, in any given trade. This is a trivial risk that wonít bother your sound sleeping at night. No matter what happens in the financial markets, the combination of your position limits and automatic stop losses will keep you from taking risks that can kill you. You must establish your own limits if you are to survive in limitless markets.
When you have the emotional steeling, position-limited portfolio construction, and mechanical profit and loss management down, the next step is to understand just how random the tactical markets truly are.
The shorter the time span over which you speculate, the more that meaningless random daily market noise affects your trades. Over 20 years supply-and-demand fundamentals truly drive market prices, but over 20 trading days anything can drive prices. As such, you have to learn to ignore short-term market movements that are likely just random noise anyway. This manifests itself in a couple key ways.
First, one of the surest ways to lose emotional neutrality is to look at your speculative portfolio every day, or even worse multiple times a day. On any given day you can be up or down for totally random and useless reasons. Over time this random noise cancels itself out, but if you let it get to you on a short-term basis it can be really emotionally disconcerting.
The less often you check your portfolio, the easier it will be to emotionally steel yourself. Nothing creates anxiety faster than seeing how far you are up or down multiple times a day. Donít do it! Realize, however, that you need to run rigid mechanical trailing stops to protect yourself so you donít have to watch your open positions constantly. The stops will get you out when appropriate without your intervention.
Second, speculation is a lot like farming. A farmer sews his seeds in the spring but he doesnít expect an instant crop to spring up overnight. Instead he patiently waits a quarter or two to see the results of his speculation begin to bear fruit. The farmer realizes up front that he is in for the entire journey until harvest, not for a quick hit-and-run miracle trade.
The farmer also realizes that one week of no rain or one week of heavy rain isnít overwhelmingly important in the grand scheme of one growing season. A speculator has to think the same way. Just because you were winning or losing for a week doesnít mean that you should linearly extrapolate that same state into the indefinite future. The shorter the frame of time considered, the more randomness crowds in and mixes up prices unpredictably. Be patient and unphased until harvest time, a quarter or two after you sew your speculation!
In order to survive speculation, you have to place internal limits on yourself since there are very few external limits in the markets to protect you. All speculators need protection from their own greed and fear, from othersí greed and fear, and from their own stupidity. A speculator running without internal limits is like a driver running way over the speed limit without a seat belt. Sooner or later the odds will catch up with him and remove him from the gene pool.
If you want to win consistently, you have to remain emotionally neutral, steeling yourself from attachment to your trades. You have to position-limit your speculative capital to protect yourself from major unforeseen moves, the deer on the highway. You have to employ mechanical sell tools to remove the immense emotional struggles inherent in closing trades. And you must refuse to get flustered by inherently random short-term market noise.
If you are interested in deepening your understanding of this greatest game of speculation as we plunge into a promising new year, please consider subscribing to our acclaimed monthly newsletter. When I recommend actual trades I use all the principles articulated in this essay. While we seek big rewards via speculation, we also take risk management very seriously since we want to see ourselves and all of our clients continue to thrive even through adverse market conditions and events.
Ready or not, speculation truly is a rare limitless environment. If you are a speculator who understands this and compensates for the great risks inherent in no limits, then you can win big over time and never risk completely blowing up and being blasted out of the game.
But if you enter a no-limit environment and donít actively protect your scarce and precious capital, then sooner or later the probabilities will catch up with you and slaughter you. The first step in surviving speculation is ensuring that you have adequate safeguards employed for operating in a limitless environment.
Adam Hamilton, CPA December 31, 2004 Subscribe at www.zealllc.com/subscribe.htm