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Loss Aversion

Does your Trading Strategy suffer because of Loss Aversion?

Loss Aversion is so important that Kenny Rogers wrote a song about it. But knowing when to cut your losses (“fold em”) is extremely difficult to do. Especially when you have an emotional tie to the thing you’re trying to cut, in this case, a financial loss.

Likewise, this applies to when a trade is in profit. A common mistake retail traders make is closing a winning trade too early (not knowing when to “hold em”). It is equally difficult to see the profit and not close the trade, fearing the profit will disappear. 

Hence why discipline in trading is such an important attribute to have. Discipline takes time and patience and is often one thing that separates professional traders from retail traders. Discipline can be learned, and careful consideration should be given to the reason you open and close a trade. 

One way traders can remove emotion from their trading is to use algorithms. It is possible to eliminate emotions from trading by coding your strategy and automating its operation. As is discussed in this podcast episode

What does Loss Aversion look like?

The (La) Investible Attribute answers this very question. It allows you to visualise three key areas of each position:

  1. Maximum positive excursion
  2. Maximum negative excursion
  3. The close position in relation to the above two points.

This visualisation allows you to quickly see how disciplined the trader is. A strategy with short red bars can indicate that the strategy quickly cuts losses. A strategy that quickly cuts losses and lets profits run will likely score highly on the (La) Investable Attribute. 

Loss Aversion and Martingale

Another interesting point regarding its use is combining it with the (Rs) Investible Attribute. Low scores in each of these can indicate the underlying strategy is operating a martingale style of trading.

Martingale is a dangerous way of managing risk. It is the process of opening new positions as the price moves negatively against the trader. The more it moves against the trader, the more, and often larger positions, are opened. 

This results in a compounding of risk, which leaves the account exposed to enormous levels of risk. The theory behind a martingale approach is that price will eventually revert to its mean.

So by opening multiple, larger positions, you reduce the distance required to break even. The length of price moves against the trader can’t be defined, and as such, leave the account at greater risk of a margin call

As an investor, always look carefully at the (Rs) and (La) Investible Attributes. If both of these are low, you should take extra care analysing that particular DARWIN. 

Trading Account Analysis

Remember, you can take advantage of Darwinex’s Investible Attributes even if you don’t have a trading account with Darwinex. By creating a free user account, you can link your existing account with your existing broker and analyse its performance using the Darwinex Investible Attributes. 

However, you won’t be eligible to participate in DarwinIA, Darwinex’s monthly prop trading allocation. To do this, you will need to open a Darwinex trading account. If you decide to open a trading account, you can permanently import your existing history from your live account with a different broker. You can find more info on this here

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Risk disclosure:
https://www.darwinex.com/legal/risk-disclaimer


Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

Loss Aversion (Behavioural Finance)

Hedging DARWIN Portfolio Risk with $DWC

In this blog post, we’ll discuss how DARWIN Investors can diversify away some of the excess risk posed to their portfolios by Loss Aversion, a common and well-researched phenomenon in behavioural finance.

In particular, we’ll discuss why it makes sense to include DARWIN $DWC in a portfolio that’s partially or entirely composed of loss averse DARWINS.


But first,

  1. A quick recap on what Loss Aversion is,
  2. Why even the most perfectly diversified portfolio of DARWINs can be susceptible to unforeseen shocks due to loss averse behaviour,
  3. What DARWIN Investors can do to hedge this risk.

Loss Aversion (Illustration)

Loss Aversion (Illustration)

Loss Aversion:

Simply put, traders are said to be loss averse when they hold on to losing trades for extended periods of time, but take quick profits on winning trades.

It yields two main outcomes:

  1. Returns growth looks fairly steady during periods of profitability, small profits smoothing the curve.
  2. Major drawdowns however, are disproportionately larger – sometimes leading to prior profits being wiped out by the closure of large losing trades that were being held on to for a long period of time.

 

Granted, a diversified portfolio of reasonably uncorrelated DARWINs has its advantages in terms of minimizing overall portfolio risk.

However, if it contains DARWINs with poor scores for the Loss Aversion attribute (La), it may still be susceptible to shocks during:

  1. Periods of market turbulence,
  2. Deep unforeseen movements,
  3. Unusually volatile news releases,
  4. Black swan events, etc.

.. where diversification benefit temporarily breaks down, owing in part to losing trade closures that distort the portfolio’s original risk profile.


What can DARWIN Investors do to protect themselves?

In one of our recent posts – $DWC – A Real Time Sentiment Index & Security – we highlighted the fact that DARWIN $DWC replicates the opposite of the Darwinex trader collective’s behaviour.

GBP Flash Crash (October, 2016)

GBP Flash Crash (October, 2016)

It typically rises during times when loss averse traders experience undiversifiable risk.

For example, $DWC profited from the GBP Flash Crash.

Undiversifiable risk also frequently presents itself when loss aversion eventually leads traders towards margin calls, causing sudden, unexpected volatility in the overlying DARWINs.

 

In such situations, portfolios that contain DARWIN $DWC can benefit from DWC hedging away a significant proportion (depending on position management of course) of undiversifiable risk experienced by investors.


When does it make sense to include $DWC in a portfolio?

  1. Investors can include $DWC in their portfolios to hedge against DARWINs with a Loss Aversion (La) score < 4.0 and Capacity (Cp) score > 5.0.
  2. Capacity (Cp) > 5.0 describes DARWINs that primarily trade long term movements. If such DARWINs also have a Loss Aversion (La) score < 4.0, the investor’s portfolio is likely exposed to undiversifiable risk at some point in the future.

    Low Loss Aversion Score

    Low Loss Aversion Score

  3. Check the Correlation of low La DARWINS against the $DWC – If they are negatively correlated, it becomes more likely that $DWC will offset excess risk should the loss averse DARWIN encounter  undiversifiable risk.

    Check Correlation of Loss Averse DARWIN Against DWC

    Check Correlation of Loss Averse DARWIN Against DWC


What composition of assets could well diversified DARWIN portfolios (hedged against loss aversion) contain?

Example Portfolio #1:

  1. 50% Short Term DARWINs (Capacity < 5.0)
  2. 25% Long Term DARWINs (Capacity >= 5.0)
  3. 25% allocation to $DWC as a hedge against loss aversion / undiversifiable risk.

Example Portfolio #2:

  1. 40% Short Term DARWINs (Capacity < 5.0)
  2. 30% Long Term DARWINs (Capacity >= 5.0)
  3. 30% allocation to $DWC as a hedge against loss aversion / undiversifiable risk.

Note: Investors should of course exercise their own discretion in selecting portfolio allocations. The examples above illustrate what such allocations could look like, accounting for multiple timing horizons whilst hedged to a reasonable degree against loss aversion.


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Darwinex - The Open Trader Exchange

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