The most common measure for risk in finance is volatility. What is probably more important than the risk for an investor or trader is the drawdown, or, even more specifically, the maximum drawdown of a certain portfolio or strategy. Drawdown measures the difference between your recent capital and the peak of your capital expressed in percentages. Big drawdowns often trigger emotions and lead to further bad decisions. For example, in a 20-30% drawdown, you may decide to abandon or change a strategy even if the strategy performs within its scope of fluctuations.
There is a way to limit drawdowns to a certain amount. William Poundstone wrote about this concept in the book “Fortune’s Formula,” a book I highly recommend. The basic idea is to split the capital across two separate accounts, a cash account and a trading account. On the trading account, you apply the “Kelly criterion” to maximize the long-run geometrical return because risking only a fraction of your account balance in a trade ensures, theoretically, that the account never reaches zero. Once the trading account shows the net profit, restore the original proportions of the two accounts. (Move the profits in the trading account to the cash account, but never in the other direction).
To illustrate the concept I did as an example. We want to limit the maximum drawdown to 10%. Therefore, a starting capital of 100.000 USD is split in a 90.000 USD cash account and 10.000 USD will be deposited into the trading account. The simulation makes 5000 trades, with a win rate of 55% and a symmetrical payoff. “Kelly criterion” suggests a 10% risk/trade. After a new rise in balance on the trading account, the previous ratio of cash is restored in both accounts; 90% in the cash account, and 10% in the trading account. Some money goes from the trading account to the cash account until it contains exactly 10 % of the overall money.
This simulations confirms the theoretical concept of limiting the drawdown to a certain amount by not breaching the 10% drawdown boundary.
In practice, there are some limitations for an exact replication. The win rate is uncertain and even if you observe the past successes/failures, it won’t show you hard evidence of how things will go in the future. Transaction costs, execution, or the ability to buy exactly the right amount of shares/futures are other problems that may arise as well. While not 100% applicable, there are a lot of things we can learn. A simplification of this concept will help to protect your capital and ensure long-term success.
- Drawdowns are the biggest enemy of every trader and investor.
- A quite sophisticated concept to deal with drawdowns is presented above. However, in practice, there are some limitations.
- Easy to replicate is the advice to have two separate accounts. The trading account only contains the money you can afford to lose, and you apply a position-sizing mechanism that depends on your trading account size (For example, 2 % risk of your trading account on each trade). After you make some decent profits in your trading account, shift some money to your cash account.
✓ Former hedge fund portfolio manager/trader
✓ 15 years of experience in financial markets
✓ Master of Science (MSc) in Business and Economics from the University of Basel
✓ Developed quantitative tools for an asset management