skip to main content
Trading Education Posted by Team Topstep May 22, 2018

3 Lessons After the Greatest Trade Ever

Yesterday, we talked about hedge fund manager John Paulson, who made what was called The Greatest Trade Ever. And just as that trade had three important lessons, so does John Paulson’s performance a decade after it was made.

While Paulson’s firm made money for a bit, some of his top funds have not done well in the meantime. For instance, Paulson’s Advantage Fund was down double digits for three years. The Paulson Partners Enhanced fund fell 35% in 2017.

In total, Paulson may have lost more of his investor’s capital since 2008 than he made in his $15 billion run. That’s because money poured in and his performance changed. Here are three lessons you can learn from his reversal of fortunes.

Lesson 1: Confidence is Good; Overconfidence is Deadly.

You can’t blame someone like Paulson, who reportedly made $15 billion betting on the failure of the subprime mortgage market, for being confident. He had a long track record of steady market gains. And being one of a very few people who saw the housing meltdown coming, he certainly earned a right to be self-assured.

However, too much of confdence can easily turn into cockiness — which can then turn into mistakes. Mick Ieronimo, Topstep’s risk manager, has observed that some of traders’ worst days in their Funded Account® come after their best days. After a hot streak, a trader can try to force the market to do what she wants.

Behavioral economists have a term for this: hindsight bias, and it can be a recipe for disaster.

Look at it this way. Let’s say you’re on the right side of the trade 60% of the time. That’s a great statistic, but it still means 40% of your trades don’t go in your favor. At the same time, you’d have a large (22%) chance that you’ll have three winning trades in a row. But after three winning trades in a row, you’re likely to start to think you can’t miss.

If you’ve just had your best trading day, think to yourself: did I have real insights, or was I a bit lucky?

Topstep Tip: Confidence is key when you’re a trader. Without some faith in your abilities, you’ll never be able to handle the dizzying heights and tumultuous tumbles the market sends your way. Just make sure you don’t fall for your own hype. As John Hoagland says, “You’re never as good as your best day — and never as bad as your worst.”

Lesson 2: Focus on What You Do Well.

What happens to a hedge fund manager after they have a period of amazing performance? They get an influx of capital. But while retail traders’ strategies will never be constrained by too much capital, hedge funds can be. That causes them to be forced into new strategies or markets beyond the one they made their money in.

That can be made worse if the hedge fund manager is called a genius, where it’s easy to get a God Complex.

Paulson’s experience with merger arbitrage and his success in the subprime mortgage market does not necessarily mean he is ready to invest in any and all products. Bad bets in pharmaceuticals, Gold ($GC), and U.S. banks have hurt his firm, with assets plummeting to just $9 billon after hitting a high of $38 billion in 2011. One fund fell 70 percent in just four years. 

Topstep Tip: Maybe hedge fund manager Steve Clark said it best in Jack Schwager’s Hedge Fund Market Wizards: “Nearly all the successful traders I know are one-trick ponies. They do one thing, and they do it very well. When they stray from that single focus, it often ends in disaster.”

Lesson 3: Size Up With Care.

It’s amazing to think that after 10 years, John Paulson may be break even with his notional performance, meaning that he may have lost $15 billion back to the market. (Though with a standard 2-and-20 fee structure, he’s undoubtedly doing well.) If that were us, we’d be back to square one. 

How many times have you had a period of stellar performance, only to increase your trading size and then lose it all back. After all is said and done, you’re back to square 1, except you are emotionally damaged.

That’s why you have to size up with care. Paulson didn’t have this luxury. His clients gave him money to invest; he had to invest it. You have more agility and mobility. You can double your account size, but only increase your trading by one or two contracts.

Topstep Tip: Show care with scaling your trading account. Become comfortable with the amount of leverage you are using before increasing. And when you do increase, keep the same mechanics that helped you grow your account (like stop losses).