(+) My Trading Blunders: A Lesson in Overconfidence and Risk Management from 2008

The Background

This story happened in January 2008 in what proved to be the early days of the biggest financial crisis of our generation (so far). It was also the time of your humble writer’s baby steps in the financial market. Fun fact: my first trading account was opened in September 2007, 10 days before the exact top of the bull market. Great timing. To be honest, this was more of a lucky coincidence for me than the average beginner trader, as I wrote my thesis a few months before that on credit markets, CDSs and whatnot, so I had a pretty good idea about the sorry state of the US subprime market, which was already in shambles in the autumn of 2007. I even made a bet on with a great friend that Lehman will trade in single digits in a year… color me prophetic. An important side note is my poetically young age of 24 at the time.

Some experienced traders might stop reading at this point because the ingredients are all there for a sad, but all too common, trading disaster. A young, beginner trader with an eagerness to outsmart the market, a degree that makes him think that he already has trading figured out, and the worst blessing of all: he is right about something. The dangerous thing about being right at the right time without experience is that ALL your trades are working and you quickly forget about risk management, money management, position sizing, and the other neat things that are there to protect your capital from the biggest enemy, your ego.

It took me 5 months to reach a +25% return on my portfolio, by trading with a bearish bias in a market that was clearly rolling over. Some would say that ok nice, but nothing extraordinary. For me, it was the best of times. I was euphoric, since I was trading with a 2% stop-loss limit and a 3% initial target on my capital, and 90% of my trades were positive. Being a math guy, I naturally started compounding those returns and quickly concluded that I will be the next Paul Tudor Jones.

The Trade Of The Century

In February, 2008 it took me exactly 0 trading days to go from +25% to -10%, and at the end of 2008 I was up by 5%, in a market that was doing exactly what I thought it would. How on earth did that happen? Well, overconfidence and weekend gaps were among the main reasons, but the root of the issue is the common error of looking for the “Trade of The Century”.

Disaster struck on a Friday afternoon on a typical Friday-Trend-Day. Day-traders might be familiar with the pattern of an initial surge (or slump) and a gradual but unstoppable drift in the direction of the trend, with sometimes a buying (selling) “panic” near the end of the session. It was a bearish trend-day, with all the major indices down by multiple percents, the VIX near the 40s, Armageddon-like headlines… one could almost hear the cries of fear and despair through the trading platform.

My portfolio was up by 5% on that day, my trades hit their targets one after the other (I was trading SP futures, FXI (the main Chinese ETF), Morgan Stanley, and VIX futures). Near the end of the session I was watching my market window with sheer excitement (error #1), and with deep regret that I am out of my positions and not profiting off the massacre (error #2). Although all of the indicators were screaming Oversold!! I started thinking about new positions (error #3). And in a moment of pure genius, I decided to double, oh wait, triple (!!!) my original position sizes (error #4 and #5). I thought it will be a “Black Monday” like open after the weekend, with the indices limit down and me walking away with 2 years of returns in one day. Sure enough, I put up the shorts on the indices and Morgan Stanley and the long on the VIX before the market close with a devilish smile on my face (error #6), while violating ALL of my risk management rules (error #7) and forgetting about gap risk (error #8).

The Fallout

The VIX at the time of the trade

The rest is history. It was the first in a series of bail-out weekends when central bankers and other leaders would sit down and come up with a plan to restore confidence and save the market during the crisis. By the US open, all of my positions were stopped out, and my stock shorts simply gapped over my stops, inflicting even more damage than I thought would be possible. I still remember the feeling when I saw FXI opening up by 10% (a stock index mind you); it was not pleasant. I lost a whopping 30% on my portfolio, and got sent back to square one, or more like square -2. I quit trading for a few weeks, which probably saved me from more losses, but after that, I needed a few more months to gather enough confidence to trade normally again.

The hardest part to accept was the fact that I was fully aware of the errors in real-time, I just shrugged them off with “I feel the rhythm of the market and it’s going lower” argument. That argument was fed by the feeling of being right, and almost invincible. On a positive note, these trades made me remember that I am no prophet, no analysis is perfect, and the weirdest things can happen in financial markets.

The Takeaway

This wasn’t my only mistake as a trader (I wish it would be), but for sure the most painful. Good thing is that you can learn a lot from it without committing the same errors that led to it. Simply put, don’t let your greed or fear overwrite your trading plan and your risk management rules. Don’t get me wrong, concentrated trades are great for experienced traders who are aware of the risks that they take on, but forgetting the negative part of the deal is unforgivable. In this case, I not only broke my own rules, but also ignored the fact that the assets I traded were highly correlated, so in reality, I had one huge position not 5 separate ones.

Stock correlations rise in times of crises (source: Business Insider)

Let’s sum up the most important lessons:

• Follow your trading rules, no matter what
• Being right is not the same as being profitable
• Expect the unexpected in financial markets
• Don’t look for the Big Trade
• Be aware that market conditions can change quickly
• Correlation sometimes negates diversification

A Timely Note on Cryptocurrencies

With the recent boom in cryptocurrencies, a lot of traders might feel like I did back in 2008; the blockchain technology is revolutionary, Bitcoin is the new gold, the market is headed for $1 trillion in market cap and you will make a fortune by investing in this technology. Remember, even if that is true it doesn’t mean that throwing caution in the wind is allowed when investing or trading the coins. Stress-test your positions with corrections up to percentage losses that might seem insane (50%, 60%, even 70%). Booms and trends in general, don’t move in straight lines, there are several emotional waves and bumps on the road.

When trading cryptocurrencies, don’t rationalize holding on to a losing trade with the “it will come back” argument. It might, but will your capital survive that, or will you panic out at the bottom? Also, in a broad correction holding several different coins might not mean that you are diversified. When the tide turns the currencies might go down together. Look at the big picture, especially when trading cryptocurrencies, and accept what the market is telling you.

As an investor, if you are in for the long run, don’t try to micromanage your holdings or catch exact turning points. Wait for deep corrections to load up, and strong rallies to ease out of full exposure if you want to trade in to the trend. This way you won’t get caught in the daily fluctuations and won’t mistake trading with investing.

What’s Your Story?

I hope that this story will help you in your path to financial freedom, and you will remember the lessons of it when the time comes. Please feel free to share your experience, trading errors, or questions regarding this post so we can all learn from it. I am positive that all traders have some similar (hopefully less painful) stories to tell.