This report will describe the lessons learned from my experience trading DXO, the PowerShares DB Crude Oil Double Long ETN (exchange traded note). Hopefully my experiences will serve as a warning and a guideline to those of you reading this. We should always seek to learn from our mistakes, and to make new ones as opposed to making the same ones repeatedly.
After my previous experience trading DXO, I figured I could use it as a vehicle for some trading gains. I believe in the long term thesis around commodities, and oil in particular. I think that $200 oil and $5 gasoline are eventualities in the US. I chose DXO as the vehicle because of its extremely low price and embedded leverage, making it, as @marketfolly remarked "a call option on oil". Nice!
The problems with this particular idea were manifold. First, DXO is an exchange traded note as opposed to being an exchange traded fund. If, for some reason, the sponsor were to go bankrupt or some other restructuring, the holder of DXO becomes an unsecured creditor of the sponsor. That adds counterparty and credit risk to the inherent market risk. Over on the Market Folly blog, there was a guest post by @tradefast which covered some of the details of trading oil via ETFs and ETNs, including the counterparty risk issues. That guest post is a must read!
The next problem is that DXO is a double long ETN. It seeks to replicate 2x the movement of its underlying index. For example, if the index moves 1% up on a given trading day, DXO should move 2%. Thankfully, in the case of DXO, this calculation is done on a monthly basis as opposed to daily, making DXO slightly less volatile than it could otherwise be.
My first, and probably biggest, mistake in wielding DXO as a trading vehicle was to not use stops. I really have no excuse for such an egregiously stupid act, and the market punished me accordingly. Generally, my stops on DXO ended up being far too tight, and I would get stopped out much sooner than I really had a tolerance for. Either that or I would get stopped out right before a bottom. While setting proper stops on DXO is difficult due to the high volatility, at least having them in place would have (possibly) prevented the $6000 meltdown that I experienced.
The second problem I introduced was using bad position sizing. This may be the most critical failure. Given the price range DXO was trading in at the time (January - mid February 2009), I accumulated a sizable block of shares, somewhere in the neighborhood of 6000. This represented at least 50% and probably closer to 60% of the assets in my brokerage account. What's even worse, I had this oversize position on a security which essentially acted as a call option! This increased the overall volatility of my portfolio and created more stress than anything. It was a completely irresponsible action on my part.
My third problem was failing to construct a proper trading plan."Plan your work, work your plan." Simple, right? Not if you don't create the plan! I was trading DXO by the seat of my pants, and thus, by emotion instead of trading it in accordance with the plan I constructed. This caused me to buy at bad times, sell at bad times, and generally overtrade. Overtrading is the quickest way to deplete your funds, it seems to me. But the biggest issue with failing to construct a proper trading plan - and adhere to it - was being swept up in the daily volatility and gyrations of DXO. For a security that moves as violently as DXO, with built-in leverage to boot, you absolutely must have resolve in your idea. If the facts change enough to warrant getting out of the trade, then so be it. All of that is testable against your plan, however. If the market conditions, when compared to the plan, tell you not to do anything, then you don't. If they do, then you do. The trading plans adds clarity, focus and structure to what can easily spiral out of control into a emotional quagmire.
So, all of that said, what practices can be put into place to prevent these mistakes from recurring?
First, creating a trading journal is a must. Dr. Brett Steenbarger talks about this here. There's really nothing more for me to say on the topic.
Second, no day or swing trades will be undertaken without an accompanying trading plan. Long(er) term position trades or investments (12+ month time horizons) won't require this level of detail to enter the position. There would be nothing wrong with doing so, though. The trading plan is a tool to enforce discipline in the face of emotion. Since the emotion, for me, is a much stronger factor when dealing with the short term trades, I will focus on optimizing my routines for those cases first.
Third, I have created a new rule that any trade, long or short, will be made with an accompanying stop/loss order set. Discipline is required to keep up with this one, at least until I change to a new broker. My current online broker (who shall remain nameless to protect the guilty) sucks but there's little I can do about that at the moment.
I may delve further into this topic and the specific actions I took that led to this point. Deconstructing them may be instructional. But for now, I hope this analysis is interesting and useful to someone.
Until next time...