With the recent popularity of the M3, I’ve noticed an alarming increase in the number of people saying that you can’t really lose all your money trading an M3. The arguments usually go along one of a few lines, mostly that it performs well even in market crashes (true) including the flash crash (true) and that you manage it along the way so that you don’t take on too much price risk in either direction (true).
If these statements are true, then how, you ask, can you lose YOUR ENTIRE ACCOUNT? After all, if I’m trading the M3, I can’t really lose all of my money so why not increase my size? Why shouldn’t I scale to the point where a thirty or forty percent loss would be considered “maximum”, as opposed to worrying about losing the entire amount?
The reason is because black swans aren’t the only birds you have to worry about. Black swans are usually describing market risk – sudden unexpected movements in price. But what about a few of the other birds that are lurking out there?
Let’s talk about the harpy eagles.
This is Panama, one of the harpy eagles at the Belize Zoo. Notice the size of his “fingers” compared to mine? Yeah. He’s absolutely got the upper “hand”. (Get it? I crack myself up sometimes.) Panama is the largest raptor in the Americas and busily patrols the jungle seeking out unsuspecting prey. Sounds a little like the clearing firm at your brokerage, doesn’t it? Yes… I’m talking about margin. Read your margin account agreement – one of the items in there is that you CAN lose more than your original investment. “But not with a well-managed M3!” you cry. Well, it may be unlikely but still possible. In a crazy market situation, your broker may decide you’re taking on too much risk and liquidate your position. Here’s a hint – like the harpy eagle, they’re not going to worry too much about getting the PERFECT prey (in this case, a good price); they’re just going to swoop in and liquidate at market. Oh yeah… that’s gonna hurt!
And what about those carrier pigeons? Yep, we’ve got those, too. Remember the old days when double diagonals were margined oddly by some clearing houses because of the FINRA rules? It was set up so that your margin was calculated as though you could lose on BOTH sides. (Happily, that doesn’t seem to be the case anymore but it was at one time.) Unsuspecting people got margin calls (and sometimes liquidation) even though their total risk wasn’t anywhere near what the calculation says. Yes, this bird is extinct now but who knows when another one will pop up?
Then there is the most common one – the starling.
This is the one that has NOTHING to do with the market. This ubiquitous little bird is the one that you don’t even notice. It flies around, not causing any trouble until all of a sudden *wham* you’ve got a million of them and they’re in your house and on your roof and in your yard and you’re in big trouble.
This, my friends, is life. Because the most likely scenario that could cause you to lose everything is LIFE. Life, unfortunately, has a habit of happening at the worst possible time and you have to deal with it RIGHT NOW. That call from your parents saying you have to fly home NOW because someone is in the hospital (which doesn’t allow cell phones), that fire coming near your house causing you to drop everything and get ready to evacuate, that earthquake, hurricane, tsunami, that cancer diagnosis during expiration week (yep! I remember that one!) … anything that forces you to ignore your trade for a day or more.
Sure, the bottom line is that it may be very unlikely that you’ll lose your entire account. Still, are you willing to bet your entire lifestyle on that? What would happen if you woke up tomorrow and it was all gone? Hopefully you’re trading an appropriate size and you’d re-fund your account and start trading again. If you’d be completely wiped out, stop and think about it. What would you do? If the answer is along the lines of “get a large cardboard box and start scouting appropriate overpasses” then perhaps you might rethink your trade size.
After all, there are an awful lot of birds out there…
Written and contributed by Cynthia Sarver, Successful Options Trader of the Month February 2016
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