We had some guests come through this week and take some of Tom’s trades blindly and got scorched so I wanted to write a little piece here about position sizing and mimicking trades. The most important lesson is “do not enter a trade unless you understand the system being traded the risk/reward and sizing profiles and more importantly the trader’s style and motivation”.
The easy part is the math so let’s start with that. In order to assign risk, that is to understand the risk you need to know the account size being traded by the trader. We will pick on Tom for this post. I am writing a separate piece on the reward side so let’s just get our heads around the risk side for now since capital preservation is the most important.
Tom’s trades are usually 25% of his traders portfolio and he refers to those as 4 ES contracts per trade. So Tom can buy 16 contracts in his account and then he is 100% maxed out. Initial margin requirements currently (3/26/2011) are $5,625 per contract. So to put on 16 contracts one needs a 5625*16 = $90,000 account. There is a 2nd type of margin requirement you need to know which is the maintenance requirement. Currently for the SP500 emini ES the margin is $4500. This allows you to slip $5625 – $4500 = $1125 on a single contract before needing to add more money into the investment, so if you slip more than that you better have some liquidity (Cash or profitable positions) or your broker will find it for you, closing out your trades to meet margin calls. You don’t want that. ( The Emini S&P500 ES contract is $50 per whole point so that is 22.5 points your position can go against you before you need to “feed” you trade with more liquidity. )
Now lets walk through a trade that Tom took this week that an anonymous trader, we will call him Sam, also took not knowing account sizing and risk and style. Tom went short 25% ES at a price of 1307 and the market went against him, in fact it went way overbought quickly and Tom decides that he will widen his stops from his usual 4 points and add to improve his position another 25% at 1310 and puts his stops at 4 points up from his 1310 entry for both the 1307 entry and 1310 entry. That puts his stops at 1314 and makes a 7 point stop on the initial and a 4 point stop on the 2nd entry.
Tom gets stopped. How much has Tom lost? Easy to calculate. Since Tom’s 25% is 4 contracts that would be 4 contracts from 1307 that went 7 points against, that is 28 points times the $50 per points is $1400 on the first entry. The second entry was also 4 contracts at a 4 point loss or 16 points times the same $50 or $800. In total the trade cost Tom $2200. On a $90,000 account that is a 2.4% loss. That is certainly recoverable and will be.
Trader Sam comes in with his $20,000 account. He has heard great things about Tom and decides he is going to mimic Tom’s trade contract by contract so Sam also enters 4 short at 1307 and 4 short at 1310 and stops out at 1314. He too is out $2200, but this time on a $20,000 account. For Sam the loss is 11%. Sam took much bigger risk than he should of.
Worse still is Trader Sally coming in with her $5000 account and $500 day trading margin and putting on the same trade and loosing 44% of her account. Perhaps Trader Sally was more prudent than Trader Sam and only put 1 contract on at those entries. Sally would have lost 11 points or $550. That is still a 11% loss and requires some work to get back to breakeven again.
So what were Sam and Sally’s mistakes? There are a few lessons here besides not understanding account and trade sizing.
First, instead of sitting back and getting to know the trader’s style, that is entry, exit and trade management, Sally and Sam just jumped right in. Tom’s March win/loss ratio is not 100% it is just above 80%, so 20% of the time Tom takes a loss. Sam and Sally hit that 20% with too high a risk.
Second, Sam and Sally did not realize that Tom often moves or removes stops so for Sally and Sam the initial risk for the trade was the initial 4 point stop. Had they known that stops move, as well as profit targets they may have entered lighter.
Third, perhaps Sam and Sally did not realize that Tom also adds to trades and that more risk was going to added if the trade started going against the initial entry.
Fourth, and this is sometimes hard for our seasoned traders to understand, is that Tom is trading three portfolios (Traders, Main and IRA). At the time of the above trade Tom was nearly all long in the Main and IRA so a hedge short with a 2.4% loss in a $90,000 account is made profitable by just a 0.5% move up in the much larger Main and IRA accounts. Tom’s goal at the end of the day is to have more net worth over all the accounts combined, not just the Traders account. You must understand your traders motivations. How do you learn that? Ask, watch and listen.
Back to Sally, who doesn’t have an account big enough to hold overnight, she also needs to know that Tom sometimes holds overnight. These are all things learned by watching, asking, reading this post and combing through the trades.
It takes a while to understand another trader’s style so one needs to be an observer and paper trade and follow the trades in a simulator before committing real funds and mimicking a traders style.
For new traders, or those new to the room, we are here to help. If you have questions about risk, account size, which trader to follow styles and motivation, Cathy, RedlionTrader (Marlin) and Tom are available to help you, Simply ask. We have many many years of doing this and surviving. questions@ttthedge.com
Hope that helps!
-Red
