Trading System #3–Naked Puts (Part 3)

In http://www.optionfanatic.com/2012/12/07/trading-system-3-naked-puts-part-2/, I explained why trading the NP system with $200K of initial equity is not feasible because the system could go bust upon max DD.  To lower the max DD %, I need to increase initial equity.

How much initial equity is required depends on how much DD I am willing to tolerate.  A market crash max DD of 50% would require at least $470K initial equity for the NP system.  Most professionals (e.g. hedge fund managers) supposedly aim for a max DD of around 20%, which would require an initial equity of $1.17M.  Since “my worst DD is always ahead of me,” I should be even more conservative and multiply this by 1.5.  Now my starting account value should be $1.76M to avoid any DD over 20%.  Suddenly, that profit of $1.19M (http://www.optionfanatic.com/2012/12/06/trading-system-3-naked-puts-part-1/) is only 67.8% over 12 years rather than 604%.  This amounts to a mediocre annual return of 4.40%.

For me personally, the most shocking aspect of this analysis is the high profit factor (PF).  I have always liked PF as a trading system metric because it describes number of dollars gained per dollar lost.  With the NP system, winning trades outpaced losers by a count of 113 to 16 and the average winner made $18,296 vs. -$54,784 for the average loser.  This amounts to a PF over 2.35, which should be like an ATM machine shooting out $100 bills!  Reality, though, is a lackluster average annual return of 4.40%.

Bottom line:  risk cannot be understood without regard to DD.  DDs will generate that pit in my stomach.  DDs will induce the psychic pain that will keep me up every night.  DDs will change my perception to imagine nothing more refreshing than exiting the market completely to free me of all the stress and worry.  The cost of selling out, of course, will be to move that max DD from the unrealized column to the realized one.

I will continue this analysis in my next post.