My Worst Trade Of The Year

• Posted by DynamicHedge
• on August 25th, 2011

Being in a bad trade is not unlike being under heavy sedation.  Once you’re under, it’s hard to wake up and cut through the fog.  In the bright light of hindsight, I should never have taken on any positional risk in this spread after May given the overall volatility in the precious metals complex and unprecedented moves in gold.  Here’s how my worst trade of the year went down.

Prior to this past spring I actively traded the $GDX – $GLD spread from both the short side and the long side.  The spread was profitable and the underlying securities were business as usual.  I always traded different position sizes depending on whether I was long or short the spread.  I would trade with my normal position size when the spread was short the miners $GDX and long $GLD.  Whenever the time came to be long the miners $GDX and short $GLD (!), I would have a much smaller position.  I laid out my argument for being overweight short the miners in the post titled: GDX – GLD Spread: Stepping Ahead of the Crowd.

I’m always much more confident to be short $GDX and long $GLD for a simple structural reason.  If you agree that the a primary driver of holding gold long is a protection against inflation then surely you will be in favor of shorting a group of companies that exchanges a physical store wealth for paper assets, right?  This is exactly what gold miners do.  They extract precious gold from the ground and exchange it for paper.  If the purchasing power of dollars is eroded gold miners have no hope of  matching the price performance of the physical asset.  Based on the inflation thesis this spread is probable to move MUCH lower.  Which means I have to step up and sell it here even though it feels unnatural as a contrarian.

This is why I’m willing to sit in the spread short for days or even weeks, but I never hold the spread long for more than a day or so.

My thesis turned out to be right.  The short trade in $GDX – $GLD was a bumpy ride but ultimately worked out.  Because it was so bumpy I stopped out of half my position.  As it turns out, I didn’t need to get ahead of the crowd.  This was my first mistake.  Trading the spread using my normal mean reversion model would have worked out perfectly but I had to go out and front run my own damn model.  I ended up taking unnecessary pain in the trade because I believed in a scenario that I had no control over — meanwhile, statistically the trade did everything it was supposed to do.  Because of my conviction to the short side and jumping the gun, I turned a big winner into a small winner.

In early May everything had played out as I imagined and therefore I was feeling a bit cocky.  I decided to put the trade on the other way even though it was against my analysis.  I wrote a note titled: Thesis Vs Statistics: Trading Market Vectors Gold Miners ETF (GDX) vs SPDR Gold Shares (GLD) .  I even mentioned in the post that I was taking a shot at the trade even though it was against my fundamental view.  The only real reason I took the trade is because the spread had moved enough standard deviations over my time horizon to justify a trade.  This was my second, and critical mistake.  Just because a trade is justified, doesn’t mean it’s a good trade.

I entered the trade and added to the position when it appeared to bottom out and started going my way.  So now I had a normal sized position instead of a very light position.  This was my third mistake.  Luckily, I stopped out of the whole position when my indicators told me to, but I had a loss twice the size as I should have.

After I came back from vacation the trade looked to be setting up again so I took another shot at it.  I even turned a blind eye to the fact that $GLD was making all-time highs — fourth mistake.  This time, thankfully, with only half the position size.  As if to add insult to injury the market crashed taking $GDX with it while $GLD soared as investors clammored for safety.  I promptly got out of half the position as the carnage was unfolding, but left the other half on in case there was a quick snapback rally.  As the $GLD continued to march higher I simply unwound the whole trade and stood to the sidelines.

Here’s an illustration of trades taken.  I traded this on many slightly different ratios so the entries and exits are approximate.  Green arrows are buys and red arrows are where I stopped out:

For the record, my unforced errors were:

• Front running my own model for the sake of a belief,
• Taking a trade against my overall analysis based on one counter argument (price),
• Changing my position sizing rules and compounding my losses as a result,
• Turning a blind eye to my rule of never shorting anything making a 52-week high.

Here is the lesson I take away from this trade.  Do not take trades that are against your fundamental analysis — no matter the justification.  When your position is not congruent with your outlook you’re in a weak mental state and you start looking for ways to rationalize your situation after you’re in the trade.  You’ll lean too hard on the one good reason for being in the trade and ignore the reasons to get out.  In my case I was in awe of how many standard deviations away from the mean the spread was, and felt it would certainly come back.  I totally ignored the big picture.  Your rules are rules for a reason.  Listen to them.

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