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?

No!

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.