Portfolio Considerations of a Trading Strategy (Part 6)

In the last post I left off by planning for the cash position ($12,000) along with the iron condor position ($8,000). This makes for multiple simultaneous positions. I can imagine a trading group discussing this. However, other portfolio considerations must be made to evaluate this trading strategy that probably are not appropriate for public discussion.

For example, I may not feel comfortable discussing the need to pay a $1,500 mortgage every month on top of $5,000 in living expenses. Suppose the backtest showed this position to average $150 profit per week, which is $7,800 per year. Am I comfortable increasing this position 10-fold to potentially make $78,000 per year? I would need $200,000 in the account for this purpose. This is a portfolio consideration.

Rather than scale up this particular position, perhaps I seek other trading strategies for diversification or hedging. How much can I expect to make from those strategies? How much cash do I need on the sidelines for those strategies? Am I able to fund all of them? These are portfolio considerations.

Zooming out even further, how much of my total net worth do I feel comfortable having in my trading account? Perhaps I only feel comfortable allocating 70% of my net worth to trading and the other 30% to bonds, real estate, etc. I should also probably have a small checking account readily liquid in case of emergency.

All the portfolio considerations described in the last three paragraphs are probably not appropriate for public disclosure because they involve matters of wealth. They certainly should be carefully thought through, however. Just how beneficial can a trading group be for the most-involved participants who trade for a living?

If all group members make a concerted effort then I think portfolio considerations can be discussed to some extent. If the common goal is trading for a living then these details affect everyone. One problem is that despite being the “elephant in the room,” in many instances portfolio considerations are not even acknowledged. Part of this is probably due to a second problem: discussion of trading strategies is much sexier than discussion of portfolio management.

I don’t know why. It just is.

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.

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.