Martin Kronicle

Mike, I took your quiz on Facebook, Are you an Investor, Day Trader, or Trend Follower and I had a question: What is the right answer for the leverage question?

On some level, there is no “right answer.” There’s only what’s right for you. Leverage amplifies both gains and losses, and I think if you’re starting out in the business you should focus on keeping your losses as small as possible. (You can always lose a lot of money sometime in the future, so why start now? Wait a while…) That means as little leverage as possible.

One trader I know pretty well, Linda Bradford Raschke, is known to only trade the contracts that she can pay for in full. In other words, she uses zero leverage. For example, with Feb Gold at $1,104, she would need $110,400 in her account to trade it. (Gold is 100 oz contract). I had a great interview with her a while back and I think she’s one of the best traders around.

Another way to look at it is “what type of results do you want to get?” You are in control of your equity curve. It’s your model, or lack thereof. You get to decide what type of shape your equity curve takes, it’s slope, and it’s potential for parabolic movement (it can be concave down too). Knowing that fact ahead of time, you can take your time and backtest your trading rules to see how your results FEEL to you.

If you don’t like how your results FEEL, don’t trade the model. Cut position sizes, cut/eliminate closely correlated contracts, or cut your margin/equity ratio down and backtest again. This way, when you begin to trade in real-time and you experience a draw down of X%, you might not sabotage your trading because the results are “in model” – that is they are within the range of your hypothetical backtested results.

How would you feel if you were down 8% and your backtested results could have you down as much as 15% ? How would you FEEL if this was the case and you were within what you predicted and what you showed your clients?

The answer to this question is very important to know. If you abandon your model because you hate how you FEEL and you do everything you can to rid yourself of these FEELINGS, you will soon be going back to doing what you did before you began your trading career.

On the other hand, if you FEEL bad from this, you can go back to your model and further adjust it to have lower risk and exposure until you FEEL HAPPY with the results.

Take the quiz – it’s for fun. Email me your results and maybe I can point you in the right direction. HAPPY trading!

Go take the new Facebook Quiz I just developed called Are You a Day Trader or a Trend Follower.

A great question came in today via email, and I like to answer these publicly while maintaining the Reader’s anonymity. The old adage from the classroom is, “If you have a question, chances are there are many other people with the same question, so ask away.” Question is in RED, and my answer follows.

For risk / market correlation purposes, how many total currency pairs at any given time is allowed before a trend trader becomes too risky?

My approach would be to study the correlations and cut position sizes down to the sleeping point. In other words, it’s the trader’s behavior that is risky, not necessarily the instrument/vehicle traded. IMHO, I trade commodity futures more conservatively than most investors handle their mutual funds: they have no sense of risk management at all. It only STARTS with diversification…

I would also note, if you’re trading the interbank, you pay special attention to the exotics as the spreads can be wide, and they can also be illiquid – which is horrible for risk management when you’re trying to exit the losing trade in particular. Test your model with an obscene skid/slippage figure for those.

Here is a funny and lighthearted quiz on the fundamentals of crude oil. Some of the answers may surprise you – I think that was part of its design.

This shot depicts two things:

1 – there doesn’t have to be a correlation between and ETF/ETN and the commodity it holds.

2 – If you have the institutional mindset of “long-only” and you own assets in futures that trade in what are called contango or carry – charge markets, you will find yourself in a situation where you have to liquidate the front month (cheaper) to purchase the next (higher) month out when you roll the contracts.

Such markets are characteristic of commodities with ample supply and the spreads suggest storage, rather than immediate demand.

Hmm? Curious to see a company such as UNG make such a mistake. They seem to have some educated, and highly intelligent members of their team, however, my guess is none are traders. Click on the graphic below to see it more clearly.

Here is a look at what is called the strip – the prices for each successive contract for the calendar. You’ll notice that for the most part, contract prices increase the further you go out in the strip. (Click on the graphic, and it will open to the full size).

The only way to trade this type of market (carry-charge) would be to implement a spread trade. Unless there happens to be a random spike in Natural Gas prices, you’re out of luck with this vehicle. This would be true for any other commodity as well.

I will write more about how to use spreads in this situation in another post. Please email me if you have something specific you’d like to know.