A follow-up thread to https://gregoryblotnick.com/risk/.
“YOU CANNOT CONTROL WHAT THE MARKET DOES. THERE IS ONLY ONE THING YOU CAN CONTROL, AND THAT IS YOUR RISK.”
Another thread on SELL DISCIPLINE – risk mgmt, protecting mental capital, stop-losses, humility, removing emotion from your process, position sizing, and cognitive biases.
(1/10) – INTRO
This thread, as with the last one, is mostly me thinking out loud…more questions than answers…”how do I know when I’m wrong, and what’s my plan for when I am”…”how can I remove emotion from my process”…”how can I stop getting in my own way”…”how can I quantify every single piece of my process”…the dichotomy of risk mgr hat vs fundamental hat, etc.
there are people out there who have the answers, and they’re on here somewhere, but they don’t tweet…this post says it best, written by global head of quant rsch at BAM + CV full of similar positions at every multi-mgr:
“As for actual professional traders and PMs, all lurkers: not one of the those I personally know posts.” –absolutely the case on here. bad color is worse than no color…so as always, do not listen to ME – I’m a nobody, all I have to offer is fuck-ups, bad decisions and piss-poor risk mgmt – and be very cautious in who you follow. The absolute best advice I can offer, echoing Buffett, is that 99.9% of professionals underperform the index, and the best thing for you to do is stop trading and buy-and-hold the S&P 500. However, what I have also learned is that people are going to speculate whether you tell them to or not, and the least you can do is try and help them do so responsibly and with some semblance of risk management. “Always use stops” is not a perfect solution, but it is one which has saved countless traders, prevented severe drawdowns and kept them in the game to fight another day.
(2/10) – PHILOSOPHY
Some high-level thoughts on risk, markets and criticism:
To get an education in markets, you must pay tuition. tuition = losses. this is the best teacher and perhaps the only teacher – pain, suffering, loss, etc – and as you read about the many different styles out there, the only way to figure out which style works for YOU is through experience.
the only way to get good at anything, in my opinion, is to go back and forth between experience and books. take risk, fail, read books to dimensionalize/crystalize your experience…then take risk, fail, read books…over and over. print out your trading blotter full of losses and stare at that motherfucker. only thru your losses will you discover what works or doesnt work for you. this tweet, as with pretty much all my prior tweets, are the output of that process…I have no problem with making myself look stupid if it will benefit the next man in the process, and have put hundreds of pages in print of stupid, mindless, and shameful shit I’ve done.
goes back to what I said in the earlier tweet, about how a young analyst can use twtr to become great – “heres my pitch, shred the fuck out of it” – this applies for everything. if there’s a hole in my inv process or risk mgmt philosophy, I would rather hear it in the form of “you’re a fucking idiot” (twtr) than in the form of a capital loss inflicted by the market.
on dealing with criticism – mentally, I picture Dantes and Mondego swordfighting in the castle (Count of Monte Cristo)…you want to have the other guy up pinned up against the wall with the point of your sword pressed against his throat…except you’re applying this to yourself. By nailing your own ass to the wall and being your own harshest critic, there should really be no instance where the crowd bothers you…wave em off, “don’t worry, I got his ass”…if other people’s words are getting to you, its a sign of some deeply-rooted insecurity or not holding yourself accountable…there should be NO scenario where someone tells you something you dont already know about yourself…so whatever is wrong, GO FIX IT.
the ultimate goal is for your image of yourself – who you see in the mirror – to be the same as who you really are, which should be the same as who you are in the eyes of God, which should be the same as how you present yourself to the world. Full convergence. No masks, life lived as an open book. With this comes inner peace, but even without that lofty goal…as long as there is a divergence, you will always have some degree of discord, agita and anxiety, some degree of FRICTION, conscious or subconscious, and this friction is what will prevent you from getting what you want out of life.
in trading markets, there is a difference between 99.9999% and 100%….one of the ultimate market truisms is “the market moves to cause the most amount of pain to the most amount of people.” max pain, always…the market will eventually sniff out your weak spot and expose it. so until then, use the world, use twtr, use criticism, to illuminate your blind spots and then grind them out in private. severe self-discipline, brutal self-efficacy, being your own harshest critic, these are the paths not only to getting what you want out of life, but in dealing with criticism – “here are my views, fuck me up, shred them.” If making myself look stupid helps make a positive change in someone else’s life, I will take that trade all day. Personally, I have no ego on any of this, I used to, all it did was get in the way, and I’m glad to be rid of it. So with that said, here are some more thoughts on risk management.
(3/10) – STOP-LOSSES IN THEORY
this type of content is helpful not just for new traders/analysts, but even experienced fundamental analysts/junior PMs, because you are likely running into the same dichotomy I ran into over and over in the past tweet – solving for P&L vs fundamental integrity, for lack of a better term.
as an analyst, your focus is 100% fundamental integrity…”downside is 20%,” and if the PM randomly liquidates you down 10%, that’s his call – the override, P&L protection > “process.”
Stops are a hard-and-fast way to limit loss. In L/S, you really see this framework today at the heart of the pod model…losing teams get their capital cut at say 5% drawdown (a partial stop-loss) and then full stop-out at 7%, whatever the math is. But the pods stay in business by being disciplined on stops. Same throughout history, Ace Greenberg at Bear Stearns was known as a great trader by being “the king of small losses.”
Some would argue against stops, they’re welcome to that opinion – in the view of a Klarman, or even Buffett, the idea of a stop-loss is lunacy and goes against pure fundamental biz analysis. If you loved it at 10x, you should love it at 9x, etc. You will have to figure out what works for you. For me, I have found that I am not that bright, and when I fight the market, I almost always lose…I believe we are hard-wired to be bad investors and bad traders, and I’m constantly trying to remove emotion from my process and find ways to “protect yourself from yourself.”
So, whatever is offered here, is just another tool laying on the ground…you can pick it up and add it to your toolbox, or you can say “nah, not for me” and keep it moving…take what helps, discard the rest.
(4/10) – STOP-LOSSES IN PRACTICE
I mentioned that the best PM I have ever seen in action, was one who was manaical about stops. At a single-mgr, at the “professional” level, what this looks like is a team of traders who each are managing several stops in real time, and for any event risk or gap risk, you work directly with the derivs desk at a bank or multiple banks to structure hedges. This is done daily and everything is “sealed up” in the final hour of trading in preparation for overnight, overnight macro positions/hedges have levels and stops that often require PM input, and so in essence, even for a book that is mostly L/S equity, it is still a 24/5 process.
Why do I say all this, because as an individual, the idea that stops will solve all your risk mgmt problems is nonsensical…they are just one tool.
In equities, a stop will not protect you from “gap risk.” If you set your stop down 5%, and the stock gaps down 15%, you get filled down 15%. In options, stops basically don’t exist (too illiquid) and the only advice I feel comfortable putting in print is “don’t trade options.”
There are physical and mental stop-loss orders. A physical or hard order is placed in the system with the brokerage, whereas a mental loss is one the trader has to act on. All new traders will assume they have the discipline for mental stop-loss orders until they don’t. They buy at $100, mentally stop-out at $90, but then when the stock approaches $90, their mind plays tricks on them. They move their stop to $80, then the same process repeats until the stock trades $50 or lower and they take an inexplicably large loss.
This hurts your financial capital, but it DESTROYS your MENTAL CAPITAL. All newbies go thru this and they learn never to dishonor a stop, because you get hit with a series of punches. First, the financial loss incurred. Second, the emotional impact of knowing you broke discipline, which shakes your confidence in yourself and in your process. This causes you to distrust your own framework. Third, the opportunity cost, as discussed last tweet – while your mental capital is shattered, a “20-hole punchcard” investment can stroll right by you.
As Ari Kiev wrote, “Traders hate to take losses because it implies admitting error. Loss aversion combined with ego leads to gambling—clinging to errors in the hope that the market will reverse. We all know this, but what is interesting is that many traders believe, at least unconsciously, that loss is less painful when it is an addition to a larger loss than when it is a freestanding loss. It seems easier for a trader to resign emotionally from playing the game, to give up and allow himself to be wiped out so he can start fresh the next day, than to keep fighting to cut losses. There is less sense of responsibility for losing big than there is for taking a smaller loss and owning the loss.”
(5/10) – PLACEMENT OF STOPS
Thru years of reading, study, experience…the best answers I have come up with are as follows.
First, “the placement of the stop is less important than that it EXISTS, and that you HONOR IT WHEN IT ARRIVES.”
Any semblance of a risk mgmt framework is better than nothing. Stops ensure that you will never be taken out of the game by one gigantic loss. If you do lose, it will be death by a thousand cuts. Yet in being completely honest with yourself, if you show up to a game and are wrong 1000 times in a row, that should signal to you that either your process is fucked up or that you’re playing the wrong game entirely – fair is fair. This is preferable to being right 999 times and then the 1000th time being a single trade that puts you at the “game over” screen – this is a common endgame for Smart Fundamental Guys. All I care about is living to fight another day and protecting mental capital, I don’t give a fuck about being “right” or looking stupid – there are many approaches to risk mgmt, being militant on stops is the best method I have found, may be right, may be wrong, do your own due dili.
Second, “place your stop at a point that indicates you are wrong.”
By confirming that you are wrong, you will have no misgivings about exiting the trade. You were wrong, move on.
An arbitrary number, say a stop-loss of 5%, is better than no stop-loss, but the issue is that you may find yourself wanting to get back into the trade. By repeatedly re-entering trades that you were stopped out of, you defeat the whole purpose of the stop-loss to begin with. Personally, I believe a stop should also trigger a cool-down period, maybe 48 hours, maybe a week, maybe a month, where you re-evaluate the trade or position. After that, you can re-enter, but the point is to “refresh” and review with fresh eyes. This overcomes a cognitive bias – “endowment effect” – we view something differently when we own it. We view a position differently when there’s P&L attached to it. The mind is weak, or at least mine is.
This also goes for setting stop-losses using a pain threshold. For example, let’s say you’re willing to risk a 1% P&L loss on a position. You’ve decided that the position should be sized at 10% of capital based on your level of conviction. This means that your stop-loss should be 10% below current — a 10% loss on a 10% position equates to a 1% P&L loss. Once again, the problem here is that you aren’t certain that the trade itself was wrong. You were stopped out on a pain threshold basis rather than on a basis of whether the trade was incorrect, putting you at some kind of crossroads re: the earlier dilemma of process vs P&L, risk hat vs fundamental hat, whatever you want to call it.
(6/10) – KNOWING WHEN YOU’RE WRONG
The most logically-sound methodology I have found is to decide first at what price you are wrong. Let’s say that this price is 20% below current. Next, you’d want to decide how much total P&L you’re willing to lose on the position. You decide that you don’t to lose more than 1% of capital. This is what dictates your maximum position size. In this case, your max position size is 5% – the math behind this calculation being that a 5% position which goes down 20% equates to a 1% total loss.
As part of pre-trade, as you place each stop, visualize the stop being hit. Visualize how you will feel at that moment, visualize the negative P&L on the screen, mentally rehearse the loss from start to finish. That way, if and when this scenario arrives, there will be no shock or disappointment. Stops are just the cost of doing business, the price a winning trader will happily pay in order to live and fight another day. It sounds stupid, but the best thing a new trader can do is build muscle memory…taking tons of tiny losses, letting stops get triggered over and over…until it becomes built into your instinct that instead of “loss = bad,” you now have “loss = part of process working as designed.”
In figuring out “what price you are wrong,” triangulating it from as many angles as possible is helpful. A hypothetical example using fundamentals, perhaps you forecast that a stock will earn $5.00 and that there should be a hard valuation floor at 20x earnings. This means that $100 is the price level — 20x $5.00 — that you expect not to be violated. If the stock trades to $75…”fundamental hat” says buy more, “risk mgr hat” says the market is telling you that you are wrong. Either you are wrong about the $5.00 in earnings, or you are wrong about 20x as a valuation floor…or just as a quick-and-dirty rule, if the market is trading flat and the sector is trading flat and you have a long down 25%, there is a pretty good chance, in my experience, that you’re missing something. But either way, by drawing some line where you are “wrong,” you should have no qualms with being taken out of the position.
The best stop-losses are those which combine both technical and fundamental considerations. The best PMs/risk mgrs I have seen, all abide by the notion what Steve Cohen says about “chart first.” Very first thing you look at in a new idea…not a “dirty secret”…much longer post, I have to avoid this rabbit hole/can of worms for now, but to put it in my own words…momentum is one of the most powerful forces in markets, if not THE most powerful. It becomes non-fundamental very quickly, and getting in front of momentum because of a fundamental view is how you blow up. Just basic risk mgmt. Again, many Smart Guys would say this is voodoo or idiocy – I am just one man full of worthless opinions, throwing tools on the ground, ignore them or pick them up, thats your call.
But for this example, if you can find some level that aligns all these considerations, i.e. your downside case is $80 based on your bear case P/E or EV/EBITDA calcs, and $80 is also some key technical level, a multi-year low, bottom of some trading range where institutions have reliably stepped up to buy stock…if price violates this level, you’ve received multiple signals confirming that your bullish view is incorrect and you’d have no issue with being taken out of the position for a loss. This is all art, not science, and the only way to figure out what works for you is thru tuition (ie losses).
(7/10) – TAKING PROFITS
Stops can also be used on position exit, thus removing all emotion from the trade start to finish.
This helps even for pure fundamental L/S where “thesis creep” is real, and you start inventing more upside once your upside target is reached – sell discipline not just on losses, but wins.
Let’s say a stock is trading at $100. Your stop-loss is set at $90 (10% lower) and you think the stock could trade to $130 (30% higher), for a risk/reward ratio of 3:1.
The cleanest way to execute the trade is to enter all three orders simultaneously: the buy at $100, the stop-loss order at $90 and the limit sell order at $130.
Now, you have nothing to think about. You will either lose 10% or gain 30% with nothing in between. Everything has been automated.
The reason to do it this way is that emotions interfere with winning positions just as they do with losing ones…and in doing so, you’re not “trusting your original work,” in essence.
The stock may trade to $130 but instead of taking profits, you will get greedy and start inventing reasons why it’s now worth $150. The next thing you know, the stock has round-tripped back to $100, leaving you with zero profits, and then eventually trades to $90 where you are stopped out. A 30% gain turned into a 10% loss because you broke sell discipline when it was time to take profits. This is one reason to automate take-profit orders in advance.
In studying great traders with long-term track records of outperformance, some basic system like this is often all that’s behind the curtain: “Never risk more than 1% of capital on a trade, and only put on trades with 3:1 reward to risk ratio.” That’s it, repeated over decades, hard discipline, with the “skill” aspect being in how to identify the 3:1 opportunities.
Stops can also apply here for protecting unrealized profits, either moving up your stop loss as the position works or placing a physical trailing stop-loss order at some price (say 10% below current) which moves higher as the stock does. You’re now in a position where all your outcomes are good ones, freeing up your mental capital and your time to search for other opportunities while that one plays out. Last, you could do all of this in partials at position entry, specifying three levels at progressively higher prices to take the position off in 1/3rds, stopped out in partials, etc. You have to keep A/B testing and seeing what works for you, there is no right or wrong answer.
(8/10) – TIME STOPS
“When I trade, I don’t just use a price stop, I also use a time stop. If I think a market should break, and it doesn’t, I will often get out even if I am not losing any money.” Paul Tudor Jones
A second kind of stop that is the time stop, particularly for shorter-term trades or positioning around events.
The reason to use time stops is that capital has an opportunity cost.
If a stock has been rangebound and you’re expecting a sharp move out of the range, but the move doesn’t materialize, your funds are so-called dead money — tied up in a position which isn’t working rather than being redeployed elsewhere.
A predefined time stop is to lay out in advance that if this trade doesn’t work in the next day, next week, next month, or whatever your chosen time frame is, you will exit.
If you place a trade, you expect the market to act a certain way (i.e. on a catalyst), and then it doesn’t – even if your P&L hasn’t changed, you should have some sort of time-based exit based on “I expected X and X didn’t occur” – by hanging around you’re probably violating your original thesis.
Another good quote on this, from Michael Platt: “I don’t trade unless I have done all the work and really have a view. If I enter a trade, and the minute I put it on, I feel uncomfortable, I will just turn around and get right out. Also, I look at each trade in my book every day and ask myself the question, “Would I enter this trade today at this price?” If the answer is “no,” then the trade is gone. Most of the trades that I do stop myself out of, I stop out because of time rather than because of a loss. If I really love the trade and get strongly positioned, and then a month later, it still hasn’t moved, alarm bells start ringing in my head. I think to myself, that is a really great idea you have, but the market is just not playing ball.”
Time stops apply to real life as well – careers, relationships – where you risk inertia/status quo/mindlessly being stuck in bad situations with no exit plan. You can decide “if this doesn’t improve in the next 90 days, I am out.” Then, for those next 90 days, you work your ass off to fix it. If it doesn’t work, on day 90, you exit and you go to sleep knowing that you did your best…nothing else you can do in life.
(9/10) – MENTAL CAPITAL
“THE HARDEST PART ABOUT TRADING IS KNOWING WHEN NOT TO TRADE.”
Aside from putting stop-losses on individual positions, you have to be able to put a stop-loss on your own mental capital, recognizing when you’re out of sync with the market. Otherwise, you can quickly lose sight of the process discipline that got you there in the first place.
This means not sending good money after bad. It may turn out that the best thing you can do is take time off, and from experience, I have seen this work in single-mgr L/S…cut gross/raise cash, take multiple days off, then come back with fresh eyes.
This requires the humility to admit that “what you do” just isn’t working…that you’re not seeing the ball, that you don’t understand the current market regime, that your emotions are getting the best of you, and that all decisions you’re making seem to have a negative expected value. Protect mental capital, remove endowment bias, blow out, refresh – “you don’t have to make it back the same way you lost it.”
What makes this difficult to put on paper is that it’s not really quantifiable – the idea of prioritizing mental capital over financial capital. Sometimes, if a losing position is causing you severe agita, the best thing you can do is blow out of it entirely and delete the ticker from your screen. Is that “good process?” Is it repeatable? Really hard to say – I don’t have the answers here, I don’t know how you’d put it into words. At the same time, even for a fundamental mgr, “I sell when my thesis breaks” can be very squishy and leaves plenty of room for subjectivity or for a weak mind to interfere.
Ultimately, it all comes back to the same debate, the dilemma at the start of this thread – fundamental mgr hat vs risk mgr hat – and where you shake out, will be dependent on your own experience.
(10/10) – FINAL THOUGHTS
“Cutting a losing trade quickly clears your head and restores your objectivity…Why do most traders lose money? Because they would rather lose money than admit they’re wrong. What is the ultimate rationalization of a trader in a losing position? “I’ll get out when I’m even.” Why is getting out even so important? Because it protects the ego. I became a winning trader when I was able to say, “To hell with my ego, making money is more important.” Marty Schwartz
The last tweet prompted q’s and DM’s along the lines of, I want numerical answers to all of this, where to cut risk, where to place stops…and as of right now, I just don’t have a great answer for you… I’m still figuring it out myself.
The truth is that after you’ve traded markets long enough, the combo of watching the P&L paired with gut feel is often your best defense against drawdowns…better than anything else in your toolkit, and if you ask any veteran trader they will probably co-sign this. Your instinct is sharp, honed by decades of watching the tape…it’s better than fundamental analysis, charts, or stops…and if you sense that something just isn’t acting right, even if its not at your stop, just blow the fuck out of it immediately and never second guess yourself about it. From a process perspective, “drawdown defense / my instinct said to protect capital” is never ever the wrong decision, and even more than that, in life, never ever ever second guess your instinct, or rationalize doing something that your gut said not to…nothing makes you feel like more of a coward.
Good luck trading, and remember, you cannot control what the market does – you can only control your risk.
LINK TO PRIOR THREAD: