Bitten by the Black Swan...Don't Let It Happen To You

Back in 2009, I wrote a blog post about avoiding black swans when it comes to trading.

Nassim Taleb talks about black swan events in his book Fooled by Randomness.  A Black Swan event is a rare but high impact event (similar to how sightings of black swans are very rare).  Black Swan events have caused many a trader to blow up his/her account.  In his book, Nassim talks about a trader who was a dip buyer and would average down on losers.  It worked for him for a long time...until he got involved in one trade where he continued to average down on a loser and the trade continued to go against him.  He eventually lost all of his money.

Well, I was bitten by a black swan yesterday.  Fortunately I was not severely hurt.  However, I learned some valuable lessons and I will share my experience with you.

Prelude to a Black Swan

Yesterday I got off to a bad trading start before the market even opened.  In my Interactive Brokers account, I played VRGY premarket off the bounce off 13.80; they had a $15 buyout offer.  I got in at 14.07.  However, I went in too big...normally I only do half position sizes when trading premarket.  My stop was below 13.80 and I got stopped out.  But then I made the mistake of trying to re-enter despite the fact that my "trading hypothesis" had failed.  This time I went in smaller, but it continued to fade, and I was stopped out again.

I then shorted HDY too aggressively near the market open, and got squeezed.  I reshorted and made the money back, fortunately.  However, I also shorted BOOM and miscalculated my position size and was in twice as large as I should have been, and was squeezed.

Suddenly I was down nearly $2K early in the day, so already I'm not in the right frame of mind for trading when starting in a big hole.  However, I have yet to be bitten by the black swan at this point.

On a Path to a Black Swan Rendezvous

I had shorted 1000 shares of XOMA overnight at 4.50 in my Speedtrader account.  I wanted to grab some shares while they were available, and I was out of day trades as I'm still limited by the PDT in that account.  XOMA spiked a bit in the morning and started to fade.  However, it then spiked again.  Right there I should've taken the $300 loss and gotten out.  But already down nearly $2K on the day, I didn't want to take another loss.

XOMA spiked over $5.  It hovered up there and looked like it was having trouble.  And this is where my risk management got worse and worse.  I started to average in higher, knowing full well I was out of day trades and would not be able to exit without my account being frozen.  Now, I had done this before with PIP and VHC and had made some huge gains off of these.  But, like Nassim Taleb's dip buyer who averaged down on losers, I was about to get bit by the black swan.

Now, normally you're allowed one PDT violation every 90 days.  However, I had already violated it a while back and signed a form that unlocked my account.  So I knew I would be locked if I exited.

I was eventually short 2800 shares at a $4.80 average.

And we all know what happened to XOMA yesterday.  It kept going higher, and higher, and higher.

Bitten by the Black Swan

I should've simply taken the loss earlier, but I didn't and it kept spiking.  Eventually I was underwater in my Speedtrader account, with negative equity.  I had to wire $2K to the account to keep it from being underwater.  But they called me and I couldn't hold the position overnight.  I covered 1900 shares at 7.20 for a nearly $5000 loss.  And I'm still short 900 shares (down over $2K on that) which I will cover on Monday if XOMA continues higher.

And on top of that, my Speedtrader account is now frozen, and I can't unfreeze it until early January (as I signed the form on October 7th).

Despite yesterday's massive loss, I'm fortunate that my month has been so good that I'm still up $3K for the month (I was up over $10K on the month).  And I'm still up overall in regards to trading.  Here I just wrote about rule adherence and my best week of trading ever, and I followed that up with my worst week ever!  But obviously I'm continuing to have the problem of getting sloppy when I'm winning.  And my rule adherence for yesterday?  30%.

Black Swans and Short Squeezes

I had gotten overconfident with shorting big runups, and had gotten away with averaging up on stocks like PIP and VHC.  The vast majority of these stocks, while squeezing, don't squeeze like XOMA did.  However, it's easy to forget that XOMA-like squeezes can happen, although not very often (hence why they are like black swans).

Here's XOMA's chart, going from under $2.50 to over $7 in 3 days:

Now look at NLST from November of 2009, where it went from $1 to $7 within 4 days:

And here is RPC in early 2010, where it went from around 20 cents to over $2 within 5 days:

Can you imagine what would happen to you if you shorted these and averaged up like I did on XOMA?  You would have likely blown up your account.  Again, these types of short squeezes are rare...ones like PIP and VHC are more common and you can get away with averaging up.  But all it takes is one black swan for you to lose all of the money in your account, and then some.

The PDT and my Risk Management

What is clear to me is that I have issues with the PDT and hard-to-borrow stocks like XOMA.  In this case, XOMA was hard to borrow and IB didn't have shares, but Speedtrader did.  I'm not under the PDT in IB, but I am in Speedtrader.  I was out of day trades, but I didn't want to miss a tank if it happened in XOMA.  So I got into a position that I should have never been in....a position where I didn't want to take a loss.  In my IB account, I have no problems taking losses because I'm not worried about the pattern day trader rule.  If I had shorted XOMA in IB, I would've simply been stopped out.  But, as I've written before, I find that the PDT messes with my head and influences me to take on more risk than I should, and makes me hesitant to take a loss.  And thus you get me averaging up on a hard-to-borrow stock, something I would never do in IB.

In fact, when I look at the equity curves of my various trading accounts I've had, I lacked consistency when I was under the PDT.  Here's my equity curve for Thinkorswim (which is now closed):

You can see that there's no consistency.

Here's the equity curve for Sogotrade (which is now closed):

Again I was inconsistent early on, although I eventually had some big gains towards the end (due to getting lucky by averaging up on PIP and VHC mainly).

Here's the equity curve for Speedtrader:

Again you can see some inconsistency.

Finally, here's the equity curve for IB:

There's much more consistency with IB, and you can see the dramatic surge in my account late since I'm no longer under the PDT there.

Now, for a long time, I was under the PDT in IB as well, but there's a key difference between IB and the other brokers.  IB won't let you enter a trade at all if you're out of day trades.  Thus, my XOMA scenario would've never happened because IB would've never let me enter a position at all.  I remember how frustrated I was sometimes about IB not letting me enter a trade that I was planning on holding overnight, but in retrospect, this was a good thing.

The bottom line is that I should not be trading when under the PDT.  It adversely affects me psychologically and it impairs my ability to manage risk and stay disciplined.  Thus, I will no longer be trading with Speedtrader until I have enough funds to day trade in it.  I have about $37K in IB right now; once I grow that to over $50K, I can move some to Speedtrader and be free to day trade in both accounts.  My Speedtrader account is frozen until early January anyway.

Having a Max Loss Per Day and Some Other Steps

Another thing that I will now implement is a maximum loss per day.  John Welsh does this as well.  Basically, once your daily loss exceeds a certain amount, you stop trading for that day.  I decided to make it 5% of my total trading capital.  I have about $40K total in trading capital right now, so a 5% loss would be $2000.  Thus, my maximum loss per day will be $2000.  Since I follow Van Tharp's rule of position sizing where I risk no more than 1% of my capital on a trade, a 5% loss would mean either I had 5 losing trades in a row, and/or that I broke my trading rules too much.  Since I started with a $2K loss yesterday, I would've stopped trading, and the XOMA issue would've been prevented.

Another thing I'm going to do is keep charts of XOMA, NLST, and RPC on my desktop as a constant reminder of how much a stock can really squeeze.  Sometimes it's easy to forget.

Down But Not Out

Yesterday's event definitely knocked me down but not out.  I'm fortunate that it wasn't worse, and that I'm still in the trading game and still profitable for the month and overall.  Like with my past setbacks, it will help me improve as a trader.  I've had big setbacks before in trading only to persevere and come back.  And that's what will happen again.