You Can't Win If You Blow Yourself Up

03/20/2014 6:00 am EST

Focus: TRADING

Steven Spencer

Partner, SMB Capital

In his 18th year of trading, Steven Spencer of SMB Capital offers some anecdotes from his days as a newbie trader, which have taught him the importance of risk management.

Recently, I have been thinking a lot about the “blowup.” In trading it is the term used to describe a catastrophic loss suffered by a trader or a firm. The blowup generally lurks in a remote corner of my consciousness, ready to be pulled to the forefront at a moment’s notice in service of proper risk management. Perhaps this past week, which marked my 18th anniversary in the market as a professional trader, has caused me to be more reflective on my own longevity and to think back on a few of the “near misses” that could have cut my career short. So I will offer some stories, two old and one new, as I think they provide some food for thought.

It was the fall of 1998 and I had been trading for about 2.5 years. Naively, after 18 months of experience, I considered myself to have sufficient skills to navigate the markets for the foreseeable future. Little did I know my understanding of true risk, which was significantly lower than I perceived at the time. I traded an account on the trading floor of a firm that employed several hundred prop traders (a true prop trading firm with no risk deposits). I was one of around eight traders that were allowed to trade their own capital but still be part of the firm’s trading floor. The capital in my trading account consisted of money I had earned during my first year of trading, money borrowed from family, and a large loan from a company affiliated with my trading firm. All in I had an account in the mid six figures of which 50% was my own money.

My trading style at the time was mainly focused on technology stocks and short-term momentum. Most of my overnight positions were remainders from intraday trades that I thought had potential to follow through. I would occasionally make longer-term plays if I was comfortable with the fundamental picture. One such play was in Sunrise Assisted Living (SNRZ). It was the leader in the “assisted living” sector, which recently had been battered. It was near long-term support, having just dropped around 50% from over $50 to around $25 per share. I estimated my overnight risk at around a 20% gap down if they issued some sort of profit warning outside of market hours. I got long 8k shares and considered my “worst case” on a gap down about a 40k loss.

I showed up to work the next morning and SNRZ was bid $12 and my mark was down over $100K. As the market opened, I traded around the position looking to catch a bounce and perhaps lower my drawdown by 20-30%. There really wasn’t much of a bounce, and by the end of the day, it had traded lower. I remember reflecting at the time that I still had some of my own capital left in my trading account as well as some savings and perhaps it was time to move on from trading. The prior two years consisted of the Asian Financial Crisis and then the LTCM debacle, which was a mini-dress rehearsal to the US financial system’s meltdown in 2008. It was incredibly stressful dealing with the wild swings in the market and it just didn’t seem worth it to me at the time. Ultimately, I decided to lower my overnight exposure in individual names so I could sleep better at night and continued to move forward.

The next anecdote involves one of my two trading partners from the late 1990s. During my first two years of trading I became friendly with two traders at my firm, and we started to share ideas and do research together reviewing hundreds of charts each day after the close. Both traders were very bright and fun to work with on the floor. After the above-mentioned episode I was more cautious, but my partners continued to grow their risk out, which worked very well as the market was in the midst of an 18-month climb to its peak in March 2000.

NEXT PAGE: Consistency is Key

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One of the two, whose initials were SG, started to load up on some micro-cap stocks and had a ridiculous run where he made over $4 million each month for three straight months. He had such a large position in a nanotech firm that the company’s legal counsel contacted him to ascertain his intentions and he matter of factly responded with: “I like the chart.” To this day I still laugh when I recall his comment. SG was incredibly bright and I believe he was one of the top chess players in the country in his age group when he emigrated to the US as a teenager. When I asked him about the chess protégé, Josh Waitzken (The Art of Learning), who was the subject of Searching for Bobby Fisher, he responded matter of factly with “he is not good.” Probably my second-favorite line of all time from SG.

Anyway, following this monstrous run of P&L the market topped out and SG had a $4 million drawdown. This caused him to lighten up on his positions. But he started to reload after the market had pulled back around 20%, which led to another massive drawdown. Eventually the firm liquidated his large nanotech position I referenced above, as it had dropped several million dollars in value as the market continued to decline. When my firm merged with another I decided to leave, and the last I had heard of SG was that he lost most of his trading capital and that the IRS was attempting to collect from him millions of dollars in taxes that he could not pay.

The SNRZ trade and two other six-figure swings I experienced in the following two years when the market made massive intraday moves continued to shape me towards the trader I am today (both ended up as positive days but remain etched in my brain). Based on my level of experience and capital available to trade, I probably am only a four on a one to ten risk-taking scale versus an eight during my first few years of trading. I have come to value consistency far more than crushing some of the better risk/reward setups that I identify. This brings me to the third anecdote regarding a trader on our desk today.

This trader is very consistent. His focus is intraday, taking quick profits as the setups start to work. In the past year he has started to take on more risk and experiment with new setups. One such trade about six months ago caused him to suffer a large loss equal to roughly 1/2 of his daily loss limit. At the time it was his largest loss in a single trade. He quickly bounced back from the loss and treated it as a learning experience.

The trader continued to take on more and more risk per trade. A few days ago the trader opened a large position in a stock with breaking news, and liquidity in the stock vanished. The trader was marked down more than 5x his daily stop loss. It was time to get flat and find out what was going on in the stock. By far the riskiest moments for traders are when they don’t have an understanding of what is happening in a market or when a market is halted and they face uncertain “gap risk.”

The trader chose not to liquidate but instead he quadrupled down. The loss the trader ended up suffering was catastrophic individually, 18x his daily loss limit, but it could have been significantly worse. In a single trade he lost more money than his top four profitable months of trading combined. My immediate reaction following the loss was to have the trader speak with the trading psychologist who had worked with him previously. I wondered if this would be a loss too damaging to his psyche to continue trading. Only time will tell.

One of the first things we teach our trainees is to get out if a stock trades against you. We probably have been accused of more than once of being too conservative with loss limits given to less experienced traders. But truthfully, if you cannot master the skill of hitting out for losses at the beginning, you have no chance of a long and profitable trading career. And as you can tell from the final anecdote, even if you hit out 99.9% of the time you may occasionally suffer a large loss—and the .1% of the time you don’t hit out or add to a losing position could jeopardize your career.

By Steven Spencer, Co-Founder, SMB Capital

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