Thoughts on entry price, and open vs closed equity

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Arthur W. Cutten
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Thoughts on entry price, and open vs closed equity

Post by Arthur W. Cutten » Tue Mar 30, 2004 12:03 pm

Consider the following two traders:

Joe Trader has 100k closed equity
His identical twin Jack trader has 80k closed equity and a position in commodity X, showing 20k open equity. They thus have identical total equity.

Now, assuming Joe and Jack have identical risk tolerance, net worth, performance goals, and so on, Joe can identically replicate Jack's portfolio by simply purchasing an identical position size in commodity X.

Joe then has 100k closed equity, and a position in commodity X. Jack has 80k closed equity, 20k open equity, and an identical position in commodity X.

Given that they now have identical portfolios, and that they have identical trading goals etc, then at any given time, there will be an optimal trading decision to be made. Recommending at any time that they should act differently would be to argue that decision X is more optimal than decision Y, and that alternative decision Y is also more optimal then decision X. It is not possible for X to be more optimal than Y, and vice versa, both at the same time. Thus they *must* act identically, in order to optimise their trading decisions.

Thus, any system or rule which results in them making anything other than identical trading decisions is logically inconsistent. It would be willingly suboptimising trading behaviour. Whatever is the best decision for Jack, is the best decision for Joe, and vice versa.

Thus, any system or rule based on a distinction between open equity and closed equity, or historical entry price vs current asset price, is logically inconsistent. It would, when presented with two identical traders with identical equity, recommend that one act differently in some cases to the other. This, by definition, is suboptimal.

Therefore, basing any trading decision on the distinction between open and closed equity, and/or the historical price at which a position was entered, is illogical.

I would be interested if anyone can find a flaw in my argument.

Ted Annemann
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Post by Ted Annemann » Tue Mar 30, 2004 12:27 pm

Similar reasoning is in this thread
viewtopic.php?p=5423&highlight=investor%2A#5423
If a new customer opens a new account with X dollars, why not immediately put her into the same positions that all the other <customers'> accounts are in? Your choices are (don't be in those positions) versus (be in those positions). If you choose NOT to be in those positions for the new investor, shouldn't you also choose not to be in those positions for existing investors? Why are those positions bad for new investors but good for existing investors?

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Transaction costs

Post by toho » Wed Apr 07, 2004 8:14 am

I almost agree. However, your argument does not take into account transaction costs. In your example, Jack may have positive expectancy on commodity X that induces him to keep the position open. Joe on the other hand will have to pay commission and slippage to open the position, and that will reduce the expected profit.

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Re: Thoughts on entry price, and open vs closed equity

Post by edward kim » Wed Apr 07, 2004 12:42 pm

Arthur W. Cutten wrote:Thus, any system or rule based on a distinction between open equity and closed equity, or historical entry price vs current asset price, is logically inconsistent. It would, when presented with two identical traders with identical equity, recommend that one act differently in some cases to the other. This, by definition, is suboptimal.
Where is Joe's stop if he takes a position in commodity x? if Joe stops out at a 1K loss, that is his choice. Jack has a 20K stop (if he risks all his open equity). that's the nature of the Turtle system where the initial hard stop might be close, while the trailing x-day exit might be far away.

Edward

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Re: Thoughts on entry price, and open vs closed equity

Post by phoenix » Sat May 08, 2004 2:13 am

Arthur W. Cutten wrote:
Therefore, basing any trading decision on the distinction between open and closed equity, and/or the historical price at which a position was entered, is illogical.

I would be interested if anyone can find a flaw in my argument.

Perhaps the difference is based on psychology and performance considerations that are not well represented in mathematics.

Maybe a more extreme example could illustrate: say that Joe trader starts with a total capitalization of $1,000 and successfully pyramids it into $100,000 (buying Qualcomm in 1999 perhaps). Say then that Jack steps in and buys 100K worth of Qualcomm with 100% of his account.

Theoretically they are in the same place once again. But from a psychological perspective and a YTD perspective, they are now obviously worlds apart.

Maybe the flaw is in the notion that different traders can have identical profiles simply via sharing open positions and account balances. Present cannot be truly removed from past and future?

Dan G

Post by Dan G » Tue May 11, 2004 9:31 am

Many people do not consider open equity to be all their money. Anyone who has traded a trend following system is aware of the tendency for open equity to not make it into that closed equity figure.

Does 'identical trading decisions' extend to postion sizing? I would argue that optimal can have different meanings for different people. For these two clones, it is not an issue.

There are lots of ways to calculate equity, and some of them only include a portion of positive open equity, or don't include positive open equity at all, or only include negative open equity. Your two clones use an aggressive method of calculating equity.

A good question would be this -

Same two clones

one with $100K closed and no open equity
one with $120K closed and -$20K open

They have the same total equity.

Does this change anything for them?

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Post by ronjing » Tue May 11, 2004 10:20 pm

The best satement re ones equity that I read was in a blackjack book I read in the 80s. The author found the common statement "their money" (as in the casino's money/the market's money)to be patently incorrect. His response was that the only way one can have "their money" is by stealing it. Logically, one can not have in his possession someone elses' money while considering it to be his own.


If that is accepted as a fact, when does the money become yours ? (equity).

My personal answer is when I consider it to be my money i.e when I consciously consider whether to close a position and realise the profit/loss. At that time, I feel that the position has changed its nature. It is less a representation and more the real thing.

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Post by leonardo » Tue May 11, 2004 11:37 pm

..., when does the money become yours ? (equity).
When the money is in your account.

Example: You start the year with $100,000. At the end of the year, if you have $277,000 in your trading account and $28,500 of it is open equity from a Coffee position, the IRS is going to tax you on all $177k of the money it considers yours so they can add money to their pile.

If I'm going to be taxed on money considered to be mine, I'm going to consider it mine!


---Leonardo---

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Post by Kiwi » Wed May 12, 2004 12:38 am

LOL leonardo.

I would agree but for a different reason. Its the amount my wife considers to be ours .... and she hates it when I give it back.

More seriously though
1) you could stop trading at that point and keep it so it is yours
2) thinking of it as the markets money can lead to an overly relaxed approach to managing it
3) the CTE thinking is what allows long term investors to build paper losses without facing up to them.

All the money that you could cash up today is yours. And you need to subtract all the paper losses.


John

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Post by ronjing » Wed May 12, 2004 9:33 pm

I've wrestled with this for years so here's a reply:
1.IRS considerations- I'm here in Australia and the thinking (as related to my particular situation) is as follows:I am in the business of trading and my inventory at year end is options. As with any business I can value these on the basis of cost, market or net realisable value (my choice). I value open profits on the basis of cost (therefore no profit) and open loss positions on the basis of net realisable value (market + commissions)-i.e bigger loss.

Therefore, the argument of let's value on the basis of IRS thoughts doesn't hold.

2. I very much agree that the attitude that "it's the market's money" is dangerous (esp. as I was even given that line from a broker years ago). However, as trades move constantly, I feel that I could not really consider any price traded to be a price that I could have got, unless I actually had the intention of trading at that price. For me this works as it provides a "reality check" and grounds my thinking- i.e this is a high stakes probability game removed from money thoughts via mathematical concepts/systems,BUT the bottom line is "this is money that's got to pay for shelter over the family's head, food in our stomachs and all the too many things that people nowadays choose to buy"

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