Risk mismanagement example

 
I still look at some of the elitetrader journals, like this one "The only way to trade with Fibonacci". Here the trader obviously did not have a realistic risk management plan and had underestimated market volatility, especially in this period of European fiscal crisis.

About his strategy:
Mean reversion strategies are very similar to short gamma exposure with options. Naturally this implies a negative skewness in the returns, lots of winners and a few significantly bigger losers. To maintain a positive EV and survive the losing trades, risk management is crucial.

Here is an example of how the trade could end badly without adequate risk management.
The trader basically bought into the S&P500 ETF (Exchange Traded Fund) SPY in May,

"
05-05-11 03:44 PM
long 200 shares SPY @ $134.22.
" 

June- As we know the S&P had been on a decline since then.

"
06-06-11 09:49 PM

So, the original base level for the fibonaccis on this trade was $129.55. But as I stated earlier, I'm not going to close out my position there.

However, it provides an important point for some of the hedging.

So with an aveage cost of $132.70 and a closing price of $129.01, I am currently down -$6,642 on this trade.

Here's the math so far for the long side:

long 200 shares SPY @ $134.22
Long 600 shares at $133.32
Long 1,000 @ $132.
Avg cost $132.70
Open P/L: -$6,642

I haven't discussed hedging yet in this thread but I am up roughly $3,801 on my hedge, bringing the total open P/L to around -$2,841.
"


The "hedge" is a long position in SH (Proshare Short S&P500), which is usually not a good idea due to term structure decay..


July- Choppy market, the trader actually had the chance to get out with a net profit. He did not.


"
07-08-11 05:53 AM

7/7

SPY: $4,788
Hedge: -$1,477
" 


August- Market dips some, trader keeps adding onto the long position


"
08-03-11 09:46 PM

Hammer outta nowhere!

8/3:

SPY: -$12,928
hedge: $2,854.84

Net for this trade:
-$10,073.16 (unrealized)
+$1,223.60 (realized)
+$1,129.72 (dividend)
--------------------
-$7,719.84
" 


September- Volatility jumps up some more, trader keeps adding


"
09-03-11 01:37 AM

SPY -$32,433.00
hedge $3,938.25

Net for this trade

-$28,494.75 (unrealized)
+$1,223.60 (realized)
+$2,931.69 (realized)
+$1,129.72 (dividend)
------------------------
-$23,209.74

Are we going back down? Good thing I didn't close out the hedge yesterday. lol.
" 


October- Still (probably) hoping for a short term rally, the trader is exposed to significant unrealized net loss


"
10-04-11 12:29 AM

SPY -$77,577.00
hedge $7,339.95

Net for this trade:

-$70,237.05 (unrealized)
+$1,223.60 (realized)
+$2,931.69 (realized)
+$1,129.72 (dividend)
+$3,561.93 (estimated dividend)
------------------------
-$61,390.11
" 


Lessons here: Even with a +Expected Value, the strategy must be practical enough that the trader would survive the worst of the impending losses. A robust business model must be able to handle all expenses easily. Learn to cut losses and be able to stop-and-reverse if need be, and consider 1st, 2nd, and 3rd order consequences for all actions. Just because something's unlikely, does not mean it'll never happen.