Trader's stories: getting over the 'blow-out'

Michael Freedman took up trading after selling his business. His early efforts were met with relative success but then came the day it all changed: “It was in late 2009, stocks were rallying but everyone thought it couldn't last. There was still a lot of fear after the financial crisis. Then we had a few down days. I was heavily into Elliot at the time. When I looked at the correction in lower time-frames I was sure I could see 5 waves down. Since corrections have to have 3 waves not 5 I assumed this was only the first leg of a bigger move. I was absolutely certain it would go lower. I kept looking at this pattern over and over and you couldn't read it any other way - 5 waves. I was so certain I waited for a small retrace and then shorted it with everything I could get  – including options.”

He pauses at this point and then after a sigh says: “The next day the market gapped up, and crucified me.”

If he had got out then he would have lost a relatively modest 15% of his account, but he didn't.

“I kept hoping the market would come good. It never did, in the end I got out much later and lost a fortune.”

In fact Freedman lost his entire account, in an example of what traders call a 'blow-out'. Most traders have had a blow-out regardless of how good they are. At least half the traders interviewed by Jack Shwager in his Market Wizard books have lost all the money in their accounts at some point in their careers, making it an affliction which affects high and low.


Most top traders have had a 'blow-out' as some point in their careers

How does the blow out happen?

The immediate and most obvious answer is a loss of risk control. Most traders operate strict money management rules. These include not risking more that 1% of their account on any one trade, not opening too many trades concurrently and using stop losses. At certain times, however, traders throw their money management rules out of the window. Sometimes they start trading with much bigger position sizes. Sometimes, its a combination of trading bigger and then not using stops. If the market turns against them they can lose everything rapidly.

The above and a combination of what Psychologists call “Loss Aversion” are often to blame for most blow-outs. Loss aversion is the human tendency to hang onto losing trades rather than closing them early. In a nutshell its people not wanting to crystallise loses. An example of this is the Freedman story above, in which by refusing to take an early hit of around 15%,  the losing position was allowed to grow worse until it became a blow-out.

Old-fashioned 'greed' is another cause: not content with the modest gains using sensible money management, traders increase the size of their bets hoping to make one big win. Sometimes this is due to unrealistic expectations about how easy it is to make money from the markets and how much can be made. In reality it is very difficult and takes years of practice to make money from trading, let a alone big money. Sometimes traders take bigger risks out of necessity as well.

Trading and investment psychologist, author and trader, Mercedes Osterman Van Essen sees the 'blow-out' as resulting from a form of dysfunctional behaviour resulting from a value system which stresses value through acquisition, status and outside material things rather than inner peace and happiness: “The reason traders suddenly blow is twofold; they accumulate a lot of pent-up emotions which are not faced, rather they are suppressed. The second reason is that most people, and that includes traders, identify with their trading results. In other words they think their validation as a human being comes through external results, like one's trading P&L.”

Van Essen sees trading as a “high performance pursuit,” which requires, “mastery not only of the system but first and foremost of the self.”  The blow-out is a form of “dysfunctional behaviour,” which comes from: “A lack of understanding of who we are as individuals and how we create our reality.”

 The problem is one of education: “Traders still are not taught that their views are back to front. They are chasing outside results in pursuit of happiness and peace, when actually happiness and peace are the pre-requisites for all success.”

Van Essen's solution to the blow-out comes from gaining spiritual knowledge: “Knowledge about the self and about how emotional healing occurs simply by understanding at a deep level how reality works...knowing how to apply this knowledge in everyday life and in the markets. Embracing the fact that we do have a choice in everything we do. And this thought is the fuel which propels us out of any fix we think we might be in.”

Van Essen sees cultivating inner peace and detachment as key to trading success.

Whether or not you agree with Van Essen's deeply esoteric views, they do chime with certain of the biases and faults perceived by behavioural psychologists.

Steve Goldstein, author of: “Behavioural Economics: Providing new Insights to market and investor behaviour,” identifies several basic human drivers which inhibit 'rational' behaviour. These include the “Need to Belong” which is the inherent human desire to belong to a group of crowd. It leads to 'herding' which can inhibit objectivity. It can also lead to “Confirmation Bias,” which is the habit of seeking information which supports one's beliefs rather than refutes them. This can develop into over-confidence and poor decision-making.

The 'Optimism Bias' can also cause traders to blow-out. Goldstein describes this as: “The tendency to overestimate the likelihood of positive events.” For example, if trader has had a successful run of trades, he may attribute the success to his own forecasting ability, and this increases his confidence. Often his winning streak has more to do with luck than skill, however, he or she may think they can 'read the market' and have a 'midas touch' leading them to place larger bets, and take bigger risks. When finally proved wrong the results can be devastating.

 In a paper called “Investor Overconfidence and Trading Volume” authors Statemen, Thorely and Vorkink, provide evidence of such an effect: “High market-wide returns make some investors overconfident because they incorrectly attribute the gains to their stock-picking talents. Investors who are subject to biased self-attribution increase their trading in subsequent periods...

One of the most successful traders in Shwager's New Market Wizards is Bill Lipschutz, known as  the 'sultan of currencies', may have suffered from optimism bias when he had his blow-out. After  inheriting a 12,000 dollar portfolio of shares from a relative, he proceeded to trade it up to $250,000 in 3-4 years. His overconfidence along with a lack of loss of risk control, however, led him to lose the whole lot in the end:

“On September 23, 1982,  the Dow went from down 30pnts to close up 20...I was very bearish and heavily long puts. I kept pyramiding all the way down. I was really pressing....I lost most of the money that Monday, and by Wednesday the account was virtually all gone.”

Blowing-out taught Lipschutz an important lesson:“I probably became more risk-control orientated. I had never been particularly risk averse. There are lots of elements to risk control: Always know exactly where you stand. Don't concentrate too much of the money on one big trade or group of highly correlated trades. Always understand the risk/reward of the trade as it now stands, not as it existed when you put the position on.”

 Lipschutz's advice to fellow traders who have lost money is instructive: “When you're in a losing streak, your ability to properly assimilate and analyse information becomes distorted because of the impairment of the confidence factor, which is a by-product of a losing streak. You have to work very hard to restore that confidence, and cutting back trading size helps achieve that goal.”

Back in his mansion in Surrey Freedman finishes poking the embers in his fireplace; then he turns and fixes me with his gaze: “That was the last time I ever thought I could be a 100% sure about the markets. Never again would I bet everything on one trade. You've got to minimize risk all the time in trading. Since learning that I've been ok.”