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Portfolio Considerations of a Trading Strategy (Part 5)

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.

Portfolio Considerations of a Trading Strategy (Part 4)

In my last post, public discussion among traders was identified as another venue where portfolio considerations are overlooked. Such discussion carries the guise of being helpful but since live trading without portfolio consideration amounts to gambling, this really is not helpful at all (think optionScam.com).

Put a different way, managing a “small” position makes it easy for me to act brave because [by definition] a negligible percentage of the portfolio is at risk. Adjusting a position often increases the margin requirement somewhat but with a small position I can adjust repeatedly while continuing to maintain negligible loss potential. I can basically adjust as many times as necessary for it to work out profitably in the end.

As discussed in the recent mini-series on Martingale betting systems, for all intents and purposes “small positions” are but a fiction. Most Blackjack tables in Vegas do have maximum betting limits, after all. Furthermore, how many people can tolerate aiming to make $5 while being down many orders of magnitude more? This is a losing business plan because eventually I will encounter a losing streak extreme enough to bankrupt my entire account.

Full disclosure of position size includes percentage of total net worth, which is not something Western culture sees fit to share with others. This statistic is a vital piece of information, however, because it may be the key determinant of whether an individual trader chooses to maintain a position or to bail with catastrophic loss in the midst of severe drawdown.

Not having these discussions with other traders leaves us to make the “should I stay or should I go” decision without any outside assistance. And why is it repeated that 70-90% of all traders fail within the first 1-3 years? The first time we encounter this harrowing decision might be the last.

My next post will offer a complete illustration of where portfolio considerations may enter the fray.

Portfolio Considerations of a Trading Strategy (Part 3)

In the last post I argued that commercial interests do not care about our portfolios as a whole. What they offer is not suitable for live trading despite their misrepresentation to the contrary.

That’s optionScam.com.

In a similar vein, traders rarely talk openly about position size when associating with each other. I have participated in or watched hundreds of trading group webinars over the last several years. Traders repeatedly present under the guise of “small positions.” It goes without saying that position sizes and account values [if] shown are arbitrary and uncorrelated with actual risk and total net worth, respectively, of the individual presenting.

Western culture is probably not alone in classifying the disclosure of wealth details as inappropriate for public discussion. This holds true for degrees of association ranging from stranger to all but the closest of family.

The problem arises when the sole arbiter of whether a trading system will work depends on the position size itself. I suspect this occurs much more than realized and has everything to do with individual differences in risk tolerance. I have touched upon this concept repeatedly as the moment when drawdown becomes sufficiently large to cause sleepless nights or persistent mental anguish. From this perspective, any particular trading system may be acceptable for some and too risky for others.

Does it even make sense to share position details without sharing total net worth? Whether the position ends profitably often depends on the ratio between maximal margin requirement (i.e. risk) and total net worth. If this ratio becomes too large then the position is closed at a big loss. Not sharing this information is to discuss position management without portfolio considerations: an artificial exercise, at best, if the two are in fact inseparable.

Does this reek of commercial interests offering position recommendations without regard to total account value or trade size? Commercial interests are not viable as trading systems and are therefore optionScam.com.

I fear the sad truth may be that association with other traders can fare no better. Association with other traders may be yet another version of optionScam.com.

Portfolio Considerations of a Trading Strategy (Part 2)

In the last post I explained how portfolio considerations make a trading system out of a trading strategy. I argued that commercial interests (e.g. newsletter writers, trader education firms, and other subscription services) care little about our real money portfolios (i.e. overall success): they just want us to pay for their recommendations.

A strategy without portfolio considerations is not a viable trading system. Without guidelines for position sizing (including deleveraging), I have no idea how likely it is to fail. Without further study to determine position sizing guidelines, I can only consider myself lucky when I trade it and make money. I basically took a shot in the dark… a gamble.

As an aside, discretionary traders gamble in this manner on a semi-regular basis and one harmful consequence is an increased likelihood of further attempts. Since they made money last time, the next time they may gamble with a larger position size. Eventually their luck will run out and they will give back some of what they made or, in catastrophic circumstances, much more. This partially explains how the bull and bear market cycles perpetuate themselves.

Back to the main: since commercial interests only offer trades (A) and since trades without portfolio considerations are not viable as trading systems (B), commercial interests are not viable as trading systems (C). If A = B and B = C then A = C. This means commercial interests do not care about our success as traders. What’s left? The opportunity for them to profit on our monthly payments or tuition fees.

That’s optionScam.com.

I would claim that commercial services for retail traders are a giant scam. I challenge anyone out there to prove me wrong.

I do not attempt to make significant money with trading strategies until I do the further research to make trading systems out of them. As a “small” position to generate enough profit for dinner and a movie it might be fine. How about as a substantial position to generate enough profit for the mortgage every month?

I would never ever try. My risk of losing much more than expected is just too great.

Portfolio Considerations of a Trading Strategy (Part 1)

My last two posts have addressed some issues one must clarify before implementing dollar cost averaging (DCA) as a CC/CSP management protocol.  Deleveraging is necessary for DCA and this moves us from considerations about the trading strategy to considerations about the portfolio.

Deleveraging is the availability of spare cash on the sidelines. Typically we think of a position as consisting of stock, options, or futures. Cash is a position, too.

A trading system includes a trading strategy along with guidelines regarding the management of multiple simultaneous positions (i.e. a trading/investment portfolio).  Deleveraging creates multiple simultaneous positions because the cash position sits in the account next to at last one CC/CSP position. The necessary guidelines address sizing of CC/CSP and cash positions. Many good sounding strategies are not viable for live trading because they lack these key portfolio considerations.

Unfortunately, most newsletter writers, trader education firms, and subscription services (i.e. commercial interests) want nothing to do with your portfolio [think liability].  Instead they often say “position size in accordance with your risk tolerance.”  Most people either don’t know their risk tolerance [until the worst happens when they realize their position size was too large] or don’t understand the consequences of trading small.   They learn about these details the hard way when sometime down the road they either lose more than they could have ever imagined or they don’t profit as much as they might have hoped.

Said another way, many people think they have found the next great “Holy Grail” of trading only to later discover it doesn’t work well in reality.  They have learned a good strategy but a poor system.

Is this misrepresentation or false advertising by the commercial interests? Is this optionScam.com?

In the SysCW archives, Rich MacDuff shows us hundreds of individual CC/CSP positions that all work out. The key question for a viable trading system is not only whether they work out but whether they can work together.

Covered Calls and Cash Secured Puts (Part 38)

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.

Covered Calls and Cash Secured Puts (Part 37)

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.

The Tall Tale of Martingale (Part 4)

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.

The Tall Tale of Martingale (Part 3)

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.

The Tall Tale of Martingale (Part 2)

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.