Worst Case Scenarios And Fatal Trading Flaws

by Olivier on May 29, 2010

Today I’m going to address a topic I meant to write about for a long time. I’ve seen so many traders come and go. If there’s one thing I’ve learned over the course of this trading journey it is that traders can lose everything. Millionaires going bust. They did well for a while but ultimately they gave back everything. There is a reason for this. In my opinion it is because their overall approach is flawed. The one thing they do not implement into their trading is to develop the following mindset:

Have the courage to do the right thing because it is right.
- W. Clement Stone

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.
- Samuel L. Clemens

Let me explain. Over the years I’ve talked to quite a few traders. I really see two different types of personalities. Both focus on near-time, mid-term and long-term trading results. What differentiates them though is that one group does everything it can to cultivate an awareness for worst case scenarios and a willingness to be prepared for these events. The other group waits for disaster to strike before thinking about implementing safety mechanisms. The risk is obvious. When disaster strikes it might hit you so hard you won’t be able to recover.

There are several examples that come to mind when it comes to worst case scenarios. Every kind of trader has different issues to contend with. Daytraders obviously face other potential problems that could put them out of business. Here’s a few that come to mind:

  • Power failures
  • Hardware failures
  • Internet connection going down
  • Trading software crashes
  • Broker website is down
  • Holding positions overnight
  • No stop losses
  • Exchanges close and trading stops ( 09.11 )

For investors and position traders with longer-term horizons other scenarios come to mind:

  • No stop losses
  • Huge opening gaps.
  • Exchanges close and trading stops
  • Inflation / Deflation
  • Currency risk
  • Broker goes bankrupt
  • Withdrawing money is denied

This is not meant to be an extensive list of potential issues, just a few thoughts to get you started. I soon tried to figure out what my personal worst case scenarios would be and started to prepare for it and protect myself. Here is just one example. One of the worst things that could happen would be being denied access to my account. This could be due to my broker going bankrupt or a general run on banks. The important thing is not the low odds for such an event. If it happens and I am not prepared I am out of business. That’s simply not an option. That’s why I protect myself. That’s the reason why early on I went for a rather high percentage of physical gold in relation to my liquid net worth. If literally everything loses its value and everybody is panicking gold will act as insurance. Owning lots of different asset classes like real estate, land, art and collectibles etc. serves the same purpose.

The idea I wanted to convey in this post is a different one though. I see lots of traders doing something that works, at least on the surface. They don’t question their approach. They don’t think about what could be flawed or what could go wrong. So they keep doing what they do until they get knocked out. The all-time classic would be adding to a losing position.

Losers average losers. – Paul Tudor Jones

Adding to losers can work. It can work a long time. It can work much longer than a rational person would possibly think. But at some point in time it will stop working. If you have cultivated a ‘conceptually flawed trading approach’ you won’t be able to reverse the situation and might not be able to trade anymore.

I have long thought about a metaphor in order to illustrate what I am talking about. The famous fight between George Foreman and Muhammad Ali is a rather good example. From Wikipedia’s ‘Rumble in the Jungle’ article:

“[...] Almost right away in the second round, Ali started lying on the ropes and letting Foreman punch him, without any attempt to attack Foreman himself (a strategy Ali later dubbed the rope-a-dope). As a result Foreman spent all his energy throwing punches, that either did not hit Ali or were deflected in a way that made it difficult for Foreman to hit Ali’s head, while sapping Foreman’s strength due to the large number of punches thrown by the champion. This loss of energy was the key to Ali’s “rope-a-dope” technique. Ali seemed to do little to resist, except to occasionally shoot straight punches to the face of Foreman. (This quickly began taking a toll on Foreman’s face and it was soon visibly puffy.) When the two fighters were locked in clinches, however, Ali consistently out-wrestled Foreman, using tactics such as leaning on Foreman to make Foreman support Ali’s weight, or holding down Foreman’s head by pushing on his neck. The latter move is disorienting and can heighten the effect of punches, since it causes a greater snap in the neck when a fighter is hit in the head and therefore increases the chances of a knockout. Ali also constantly taunted Foreman in these clinches, telling Foreman to throw more and harder punches, and an enraged Foreman responded by doing just that. After several rounds, this caused Foreman to begin tiring. As Foreman’s face became increasingly damaged by the occasional hard and fast jabs and crosses that Ali threw, his stamina looked to be draining from him. The effects were increasingly visible as Foreman was staggered by an Ali combination at the start of the fourth round and again several times near the end of the fifth, after Foreman had seemed to dominate much of that round. Although he would keep throwing punches and coming forward, after the fifth round Foreman was very tired and he looked increasingly worn out. Ali continued to taunt him by saying “they told me you could punch, George!” and “they told me you could punch as hard as Joe Louis.” Finally in the eighth round, Ali landed the final combination, a left hook that brought Foreman’s head up into position so Ali could smash him with a hard right straight to the face. Foreman staggered, then twirled across half the ring before landing on his back; he finally managed to get up, but it was too late. The fight made clear just how great Ali was at taking a punch and also highlights the different, perhaps dangerous, change that Ali had made in his fighting style, by adopting the rope-a-dope, instead of his former style that emphasized movement. Film of the Zaire fight shows Foreman striking Ali with hundreds of thunderous blows, many blocked, but many getting through. Foreman mostly struck to the sides and kidney region, but also landed some vicious shots to the head, seemingly with no effect. This fight has since become one of the most famous fights of all time because it resulted in Ali, against the odds, regaining the title against a younger and stronger Foreman. [...]”

The example is far from perfect but it still exemplifies parts of my point. Odds were stacked against Ali. Looking at the fight it seemed Ali was employing the wrong strategy and would end up losing. Let’s analyze Foreman’s strategy here for a second. Everything looked like it was going his way. Ali adopted a style that should have been very advantageous to Foreman. So Foreman kept doing what would seemingly work if he only kept doing it long enough. He simply kept doing more of it without giving enough thought to possible worst case scenarios. Also notice the fact that due to emotions kicking in, Ali taunted him whenever he could, Foreman’s distraction increased and his ability to change a losing strategy decreased. He ignored the warning signs and simply wasn’t able to properly adapt to a new situation.

The picture perfect example, and this is a very important distinction, would have been a fight with almost no physical damage to Foreman. No recurring punches to the head. Not getting tired. Almost no warning signals whatsoever. Then, all of a sudden losing due to a ‘flawed strategy’.

The markets usually issue multiple warning signals, similar to the punches George Foreman had to endure, before things go sour. But, and that’s a huge ‘but’, there are scenarios where this is taken one step further and those warning signals are not generated. Think averaging down and being ‘rewarded’ for such an approach. Also think of what is commonly referred to as ‘Black Swan Events’.

Conclusion:

If you keep getting hit and make no real progress heed the warning signals the market sends out. Even more importantly though, spend some time figuring out what could really hurt you or put you out of business without being given proper warning signals. Whatever you decide to do, offer no excuses.

Risk comes from not knowing what you are doing.
- Warren Buffett

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