Recent discussion has labeled investment newsletters, trader education firms, and even informal conversation with other traders as different venues where portfolio considerations are overlooked. Today I begin to illustrate exactly where these portfolio considerations might apply when evaluating a trading strategy.
Suppose we participate in a weekly trading group and today is my turn to present. I show a 10-contract weekly iron condor position with a margin requirement of $8,000. My profit target is 10% or $800. I detail the trading strategy with position setup and risk management [adjustment] guidelines. I show last month’s successful trade and everyone is all smiles. Right?
Because one trade never makes a trading system, I need to zoom out to determine whether this trading strategy is for me.
Suppose I show three years of backtesting results and the worst year-to-date drawdown is $8,000. Does this suggest I need $8,000 to implement this strategy?
First, I would likely bankrupt the account or come pretty close. People generally become concerned once drawdown exceeds 10%. In 2008-2009, the stock market fell 50-60% and people were completely devastated from that. I can hardly imagine a drawdown approaching 100%
Second, some trading guru once said “your worst drawdown is ahead of you.” In general, the longer the time interval the greater the variety of market environments available to test a strategy. Three years is a very limited backtest. In some future year, this trading strategy is very likely to post a drawdown [much?] greater than $8,000. I will arbitrarily deem $20,000 (2.5 times) as necessary to implement this trade: $8,000 for the iron condor and $12,000 as supplemental cash in the account.
If I am being entirely honest when discussing this trade then I should also realize my weekly profit target is now 4% rather than 10%. The margin requirement of the trade might be $8,000 but I have now set $20,000 aside for the trade.
Further calculations will be more about gross dollars. I will continue with these details in the next post.Categories: Money Management, Option Trading | Comments (0) | Permalink
My last post identified when to dollar cost average (DCA) as an issue to clarify for those who plan on doing it. Today I will cover two other DCA issues that should be clarified prior to trading live.
How much additional capital to commit is a second issue requiring attention. Doubling the position size is not the same as doubling the capital allocation. A stock that has fallen 50% will only require half as much capital to DCA. If I actually double the capital then I will more than double the position size. The latter will benefit me if the stock reverses higher because my position breakeven will be even lower. If the stock continues lower, however, then I will lose money at a faster rate.
What I wrote in the last post also applies here:
> Perhaps you will do some backtesting and see what best
> fits your sample. I don’t have an answer to this question
> and I don’t think a correct answer exists.
In other words, no specific approach will work for all situations.
Besides how to DCA, a third issue to define is size of the cash position. Capital on the sidelines will dilute overall returns. Without this spare buying power, DCA cannot be implemented. In a worst-case scenario, DCA’ing all positions might require 50% of my capital on the sidelines ready for deployment. Although individual positions are selected by the Math Exercise to achieve 15-18% annualized returns, this only represents 7.5-9% annualized if half my capital is on the sidelines.
If this decreased return is not enough for me then I have some decisions to make. Do I incorporate an alternative exit strategy if the market moves against me? Do I leave position size constant? How will either approach affect returns?
Of utmost importance is a need to completely define the trading plan and to understand what I can likely expect before going live. This will minimize the probability of becoming disenchanted when capital hangs in the balance. As always, the worst possible ending is a forced psychological exit when things get ugly that leaves me licking the wounds of a catastrophic loss.Categories: Money Management, Option Trading | Comments (1) | Permalink
I devoted the last four posts to discussion of the Martingale betting system because martingaling is to gambling what dollar cost averaging (DCA) is to investing/trading. Today I discuss incorporation of DCA to the CC/CSP trading plan.
The first step is to determine my maximum tolerance for loss. This is critical because I will approach that limit twice or four times as fast after doubling down once or twice, respectively. If I don’t know my maximum tolerance for loss–and most traders who have never experienced a volatile market and/or substantial loss do not–then the safest advice is probably to assume my tolerance will be small and to avoid doubling down altogether.
For the more experienced trader who is willing to commit additional capital, the next step is deciding when to DCA. The only recommendation MacDuff offers for this is “when a stock is on sale.” He seems to DCA inconsistently in his archives of successful positions.
Unfortunately, determining when a stock is “on sale” can only be done in retrospect. Any stock that went bankrupt was first down 10%, 50%, or more. Any of those levels could be considered “on sale.” Such identification might later be revised with the classification “falling knife” and dire regret had I acted and committed additional capital at the higher stock price. This is the risk of DCA and we can never get around it.
When to DCA is therefore an individual decision that must be made in accordance with your risk tolerance. Perhaps you will elect to DCA when the stock falls 30% or 50% or more. Perhaps you will do some backtesting [with a survivorship-free database] and decide what best fits your sample. I don’t have an answer to this question and I don’t think a correct answer exists. Period.
I will continue with more DCA discussion in my next post.Categories: Money Management, Option Trading | Comments (1) | Permalink
Given unlimited capital, a Martingale betting system is guaranteed to make money because no matter how extreme the losing streak, at some point I will win. Casinos employ two additional tactics to make sure this does not happen.
I have described at length how large the next bet can become relative to the initial bet during an extreme losing streak.
If this doesn’t sound dire enough already, here’s the kicker in the world of Vegas: even if I have enough money to cover the next double, at some point I will not be allowed to. On a $5 [maximum payout] table, for example, casinos will usually limit the maximum bet to $500-$1000. After eight consecutive rounds of bad luck, I will no longer be able to recoup my losses with the next bet. I might therefore have to win two consecutive games with large bets to end up net positive.
Probability of profit decreases markedly if I must win multiple times in a row to recoup my losses.
The martingale gambler is targeted further by casinos that also raise the minimum bet. Martingaling relies on the number of times I can double while still remaining within table limits because I am always less likely to lose (n + 1) consecutive times than I am to lose n times in a row. I could simply play at a table with a larger maximum bet except typically the minimum bet is proportionally larger as well. This maintains the same number of betting doubles before table limits are reached.
Here’s the bottom line: if I lose enough times in a row with a Martingale betting system then I will go broke and not have enough money to continue or I will reach the table limit. While martingaling can work in the short term, the longer I play the more likely I am to encounter an extreme losing streak forcing a meeting with my demise since I will be prohibited from raising my bet high enough.
In Vegas and on Wall Street, there is no free lunch despite an occasional illusion to the contrary.Categories: Money Management | Comments (0) | Permalink
Here’s a brief review of what I have discussed with regard to Martingale betting systems.
Although rare, extreme losing streaks most definitely occur. Martingale betting therefore favors shorter playing times because the longer I play, the more likely I am to encounter an extreme losing streak.
Martingale betting systems involve doubling my bet every time I lose. A long losing streak could easily have me down over $10,000 from a $5 initial bet.
Most people could never tolerate facing a loss that is orders of magnitude larger than the potential gain. If this has never happened to you then consider it extensively before attempting a trading system that carries a large potential drawdown.
I’ll go one step further…
If this has never happened to you then I strongly suggest assuming you would not be able to tolerate it either! Find another trading system or position size the system very small to prevent a heavy drawdown from significantly denting your total net worth. The alternative is learning something about yourself at the worst possible time: when you exit a trading system only to realize a catastrophic loss of capital.
Unfortunately, this has happened to me.
Would you ever stand being down over ten grand with the hopes of ending up five bucks? Most traders and investors cannot sleep at night or deal with the anguish of losing so much money when they stand to make so little even though they are one win away from vaporizing the entire loss.
Does that make us weak? Yes but no: with every additional loss, the huge loss I face doubles again! Maybe getting out with a few bucks to my name is better than losing absolutely everything.
In my next post I will describe a couple other ways casinos stack the deck against Martingale betting systems.Categories: Money Management, Option Trading | Comments (1) | Permalink
In the last post I mentioned, “while rare, extreme losing streaks do occur.” This is an important detail worthy of extra time.
One of the best bets in a casino is found in the game of Craps. The table I presented in the last post assumed even money bets, which are very hard to find in the real world. Casinos make their money on the house edge. Betting the pass line in Craps offers a 49.29% probability of winning, which translates to a low 1.41% house edge.
Consider a simple Martingale betting system with $1 as the standard bet. Suppose I have $2,047, which can cover up to 10 consecutive losses. Here is a table of outcomes:
Looking at the probability column tells us just how rare those extreme losing streaks can be. The chance of five consecutive losses is about 1.6%. The chance of 10 consecutive losses is 0.055% or one out of every 1818 times. The chance of being struck by lightning (based on number of people hit each year) is one out of three million. The odds of winning a million dollar lottery are roughly one in 10-12 million. Compared to these numbers, then, the odds of 10 consecutive losses are pretty good!
How scary is that?
That there is any chance of an extreme losing streak means the Martingale betting system favors shorter play over longer play. The longer I play, the more likely I am to encounter such a losing streak. If I knew how many rolls per hour occurred in a particular Craps game then I could calculate the odds of experiencing one based on playing time.
Regardless of duration, the ultimate arbiter of whether I will “live to play another day” lies in the hands of Chance.
I will write more on Martingale betting systems in the next post.Categories: Money Management | Comments (1) | Permalink