Open Trade Equity – The No. 1 Villain of the Investing World

by kirangarimella on July 5, 2013

Picture this: you bought 200 shares of stock XYZ a month ago for $20 a share (most likely based on the opinion of some talking head on CNN).

It is now Saturday.  Just before you head off to a BBQ at your brother-in-law’s place, you decide to check your account.  What do you see?

The stock’s up and closed at $30 a share.  Your account is up $2000.  A helpful ‘Gain %’ or ‘ROI’ column on your online account shows you 50% gain (annualized, that’s 600%)!

At the BBQ, you smugly let drop that your stock is up 600%.  You are the envy of the party.

For the next few weeks your account keeps rising.  The greener your account, the greener is your brother-in-law with envy.

One fine day, your car breaks down and your kids’ dental bill comes in.  You decide to cash in your stock.  You access your account online and get the shock of your life: the stock is now trading at $5 a share – you lost $3000!

How did this happen?

OTE (Open Trade Equity) is what happened.  Also called ‘Account Balance.’   One of the most deceptive and misguided concepts ever invented.

It lulls you into a false sense of accomplishment and security, and then cuts your legs off just when you are getting ready to run the race to wealth, freedom, and happiness.

Here’s a tip for your financial sanity: completely ignore the account balance or OTE numbers in your brokerage account.  The word “Open” in OTE means your money is open to complete evaporation, just as all the boiling water in your pan will evaporate if you leave  the lid off.

A better concept to follow is what I call the True Trade Equity (TTE).  While this idea is well-known among sophisticated investors, it is unknown among the lay public.  Wall Street and brokerage houses have a vested interest in hypnotizing you with OTE and Account Balance (so they’ll let you borrow on margin and let you dig yourself deeper into a hole – but that’s another story).

Read this carefully – it is the difference between life and death for your account.

If you buy 200 shares of stock XYZ for $20 a share, what is your OTE right away?  It is $4000.  What is your TTE? It is -$4000 (yes, negative).  Or, if you make the lazy assumption that a stock (especially XYZ because it was recommended by a loud-mouthed crackpot on CNN) can’t possibly go to zero and might go to $10 in the worst-case scenario, then your TTE is -$2000.

90% of “investors” don’t even get to this point in their thinking.

A very small proportion of investors actually put in a stop loss order.  Let’s say you think that, based on your analysis, if the stock goes down by $2 then your reason for buying the stock was not valid anymore and that you’d prefer to limit your loss to $2 per share.  So, you put in a stop loss at $18, meaning that if the stock ever touched $18 in the course of trading, your 200 shares would be automatically sold (either at the prevailing market price or limit price, depending on how you set it up).

What’s your current TTE with this stop loss in place?  It is -$400.

If the stock moves up by $2 to $22, what’s your OTE?  It is +$400.  How about your TTE?  It is still -$400.

If the stock moves up to $26 and you move your stop to $22, then what is your OTE? +$1200.  Your TTE? +$400.

Isn’t TTE much worse?  Yes, but it is realistic.  The OTE is pure fiction.  Your brother-in-law, who has no stop in place and boasts that he “made” $1200 on XYZ stock is lying – unless he actually sold his 200 shares at 26.

Until you sell, you have made nothing.  If you have a stop in place, you are at least partially guaranteed to limit your risk or lock in some profits.

I say, ‘partially’ guaranteed but not ‘completely’ guaranteed.  That’s because even with a stop loss order in place, it is quite likely that the stock will gap down on the open on some day to, say, $3 (because after the markets closed the prior day, the news hit the fan that the CEO of XYZ was caught south of the border with a suitcase full of loot, the CFO had shot himself, the SEC had filed a multi-trillion dollar lawsuit against the company, all the large customers had cancelled their orders, the one and only factory of the company was burnt down, and that the company’s only warehouse in South America was confiscated by the local tinpot dictator – you want more reasons?)

In that case, your stop loss order would kick in at $3 or just a bit lower (assuming you had the good sense to place a stop loss market order, and not a stop loss limit order, in which latter case, you’d be out of luck).  You would have lost $3400 or worse by this point – perhaps not $4000 (but why quibble?).

Generally speaking, though, TTE is the number to track rather than OTE.  Your TTE is a reasonable safety net.  With OTE, you are doing backflips 150 feet above the ground on a thin, frayed steel wire that has a coating of oil on it.

The OTE devil shows up in many forms.  One of them, for example, is home equity.  Again, a meaningless metric because until you sell your home and pocket the cash, your home equity means nothing (except, as I mentioned, for financial institutions to lend you more money – thereby making you more indebted to them – and for financial ‘aid’ sources to lend you less money for your kid’s college).

TTE is a sane, conservative, responsible metric.

Along with it, you should adopt the following fundamental attitude when it comes to investing:

Paper profits are illusory, paper losses are real.

 

{ 1 comment… read it below or add one }

Site June 14, 2016 at 9:11 pm

Plus if you were in any real trading firm, you d find it pretty much impossible to use stocks to hedge a credit market risk. The basis risk would be huge and there would be plenty of day when you d lose on the hedge and the underlying. Most firms with any sort of decent risk management system wouldn t let that sort of trade be put on in the first place.

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