Protecting Windfall Gains

A whole generation of new (and old) traders dreams of life-changing gains through highly concentrated bets. The reason for such persuasive sentiment is that the current speculative environment raises the chances for success significantly. More so than in other market regimes, the opportunities this past year were plentiful: from speculative SPACs, to highflying tech stocks, to Crypto, all the way to everyday commodities like corn or lumber — a good-sized trade in each of those areas could have set you up for years, if not life. 

Unsurprisingly, tales of Dogecoin or Gamestop millionaires stoke people’s envy, luring in many just before the music stops. However, a substantial number of these trends (often inversely correlated to how silly the idea seems to be) have lasted for a considerable length of time, which made it possible for intrepid YOLO traders to participate — even if they were only half attuned to looking for the new thing. Long-term experience as a trader or investor, with an eye on risk control, are more of a hindrance than an asset during that stage in a speculative boom (much to my chagrin).

But making a windfall gain is only half the game — it is even harder to preserve it.

Even “silly” gains have often been remarkably resilient in the current market, but significant, intermediate drawdowns wipe out leveraged players.

A cursory look at the current investment landscape clearly shows: if returns look too good to be true, they usually won’t last very long. At the very least significant downside volatility is to be expected, and will often wipe out initial stakes when leverage (for example, through the use of options) is used. Especially the latecomers are hit hard by 40% to 60% drawdowns in each of these asset classes — and routinely even deeper in single names. 

Unfortunately, many people, who managed to make it to the top, ride the trend back down, because it takes the opposite qualities and behaviors to keep the profits versus making the gain.

YOLO versus Reason

While reckless behavior has a chance to pay off handsomely with so many opportunities around, it is virtually guaranteed to lead to a financially worse situation than one started at eventually. If not through leverage, this will occur once the environment changes and HODLing ceases to be ultimately rewarded, when deep drawdowns morph into lasting declines.

In an uncanny way, mainstream media manages to top tick many trends in its reporting. A New York Times story about a Dogecoin millionaire is a great example of how it managed to ring the bell for the ensuing carnage in the crypto space.

Glauber Contessoto, in a pure YOLO trade, poured $250.000 (his lifetime savings leveraged by debt) into the crypto joke Dogecoin. By the beginning of May his stake was worth well over $2 million — arguably enough to last a lifetime when prudently invested and paired with a moderate lifestyle. Right now it is still worth half as much (though the drawdown extended to over 70% during last week), but no-one knows who the joke will be on in the end.

Bitcoin’s historical drawdowns; Pragmatic Capitalism

By comparison, we are still in one of the shallower drawdowns in the short history of crypto currencies. And yet, in the first sharp drop after a long run-up, last week over 775.000 crypto accounts were liquidated to the tune of $8.6bn, because leverage led to margin calls in a cascading stop run. A high propensity for risk-taking, which was highly rewarded initially, quickly led to an evaporation of profits later on.

A luxury problem

A solution to the problem is easy to implement and seems to be quite obvious: simply take a majority of the gains off the table. (One could even leave a large chunk of the profit in speculative ideas to tickle the FOMO urge.) You have already made it after all and excessive risk-taking is simply unnecessary. Yet behavioral biases will make it very hard to implement this solution, as YOLO gain mode and capital preservation mode, which perfectly complement each other during times of excessive speculation, are extremely hard to juggle in your mind. The timing of an exit will never be exactly right, and therefore feel bad.

The key problem is overconfidence. In the midst of a winning streak, it is hard to fathom that a beloved asset could ever go down. The same mechanism comes into play when a trading strategy has a long series of profitable trades. Confidence increases and so does the tendency to overtrade and eventually give back a large portion of accumulated gains.

Taking a step back to analyze what the money actually means for ones situation in the real world may work to make a change towards more sustainable behavior. Because switching to preservation mode for part of the gain is essential, reasonable and easy — why not do it?

After all, it is a really nice problem, if you happen to have it.

Good luck with your trading, and thank you for reading!


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One comment

  • Yes, I’ve been there. Connecting gains to the real world is destructive when you put on a position or under water. But it is very helpful when you have a windfall gain. I have let slip big six figure gains. Afterwards I woke up and said OMG I could have lived at my favorite Caribbean resort for several years. I could have traveled around the world a few times. But the treacherous thing for me is that an incremental few hundred thousand won’t significantly change my life. So I hold positions waiting for a seven figure gain that will make a difference. Very destructive. Considering therapy for my affliction.

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