How the filthy rich handle drawdown

I'm halfway through reading Theo Paphitis' (BBC Dragons' Den) autobiography and noticed that the self-made ultra-rich have something in common. Almost all of them came perilously close to bankruptcy at some stage, usually early in their "career".

 

In trader parlance, you can say that their drawdown came close to 100%. In fact, many of these millionaires / billionaires took on astronomical levels of debt at the lowest point of their careers, so you can say that drawdown exceeded 100%.

 

Can traders learn something from this? Trading is just like any other business. You have suppliers and customers (both from the market), you buy low and you sell high, you use other people's money (OPM) via leveraging and you have overheads that you want to minimise (spread and overnight swap rates).

 

Quite often these self-made entrepreneurs would fully invest themselves in a single enterprise. That would be the equivalent of putting in 100% equity into a single trade. A big no-no.

 

So are entrepreneurs like Theo Paphitis and Richard Branson stupid? Did they fail to manage their risk? Or perhaps the risk they took fits their psychological profile?

 

I'm not saying I have the answers. But drawing a parallel between entrepreneurship and trading is interesting and I think valuable lessons can be gleaned from this.

 

To be fair, these entrepreneurs began to manage their risk better as their wealth accumulated. These days Richard Branson segregates each of his businesses into autonomous units so if one blows up, it doesn't affect his business empire. That's like risking 1% equity per trade. It's a very managable level of risk. Reading their biographies, you realise that many of these entrepeneurs were somewhat naive when first starting out and I guess got "lucky" when their 100% equity trade won. We don't read the biographies of those who lose everything.

 

The journey to wealth usually goes like this:

 

1) Risk big early on

2) Hit a home run or lose everything

3) Once you're rich enough, slow down and manage your risk

 

"Losing everything" isn't the end-all, be-all. I guess these entrepreneurs accepted such a possibility. As long as you have two hands and a brain, you can always regather some skin to get back into the game.

 

But no-one ever got filthy rich by being conservative. If you do play it safe, you may end up as a single-digit millionaire by retirement. It's not a bad position. But to get into the hundreds of millions and above as a self-made man, I don't think there's any way around taking large risks.

The future: managing my own money, or other people's money?

I spent the last week having a good think about my future's direction. As a professional trader, I have two options:

 

1) Manage my own money

 

2) Manage other people's money

 

I've been reading CASHFLOW Quadrant from the Rich Dad Poor Dad series, and according to Robert Kiyosaki, most wealthy people obtain their wealth by utilising other people's money (OPM) and time (OTM).

 

If you're a professional trader / investor with a solid track record of profitability and low drawdown, investors will throw money at you. If you do decide to manage other people's money, your main source of income will come from fees. An advantage of managing OPM is scalability. There's not much difference in effort when investing $1m or $100m. Your investment or trading system(s) should be very similar in both cases. However, in the latter case, your income increases a hundred fold. Not bad at all. If you're a profitable trader using your own money, why not charge investors a fee to piggy-back on your success?

 

On the surface, this looks like an attractive proposition. But here are my reservations:

 

1) It becomes almost like a job. You're no longer answerable to yourself, but also to your investors. You'll be required to meet all sorts of regulations, expectations and KPIs. Most traders become so because of the freedom, and this sets you back in the corporate world, albeit you are your own boss.

 

2) Your psychological profile may mismatch with investors. Now, this can be partly remedied by being selective about those who invest with you. Most passive investors seek steady and reliable returns. In contrast, most traders want to strike it rich and retire as early as possible. Different goals. Many investors will balk at the prospect of losing 10-20% equity in a short-term drawdown, but traders know that such drawdowns are expected during long-term wealth creation.

 

There's prestige in finding your own hedge fund. Pyschologically, though, I don't think it's for me.

Win on NZDUSD, equity update

My trade on the NZDUSD resulted in a win. I used a 1.25:1 reward:risk ratio when trading with the trend.

Equity Update

Since going live at the start of September, my equity has grown by 5%. If annually-adjusted, that should mean a performance of 17% p.a.

I've used various levels of risk, from 1% to 5% per trade. I found 5% risk to be quite high, particularly for mechanical trading. I've reduced my last few trades to 1% risk or less and found it much more comfortable - in fact I forget I have trades open at this level. The key to winning mechanically = low risk * high frequency. It's the high frequency part I need to focus on.

Relationship between profit factor and risk per trade

I stumbled upon this discovery by accident.

 

As a general rule of thumb, traders risk 1-2% of their equity per trade to control their drawdown when they lose.

 

It's also another general rule of thumb that if you are using a trading system, you optimise the variables within the system to maximise your profit factor (within reason - if you over-optimise, you end up curve-fitting which has little predictive value).

 

Thus, we trade a system with maximum (or near-maximum) profit factor, and risk 1-2% of our equity per trade.

 

I will explain why this may in fact sub-optimal under certain conditions.

 

I was tinkering with my low-volatility breakout system "Hermes" and found that a reward:risk of 0.5:1 provided a better profit factor than reward:risk of 2:1 (1.49 versus 1.33, respectively). One of the trading mantras you'll find on the internet is "never trade below 2:1!", which is why I tended to disregard any R:R below 1:1.

 

Nevertheless, I decided to plot the equity curves for 2:1 and 0.5:1 R:R, at 1% equity risk per trade. Results are below.

Equity curve for 2-to-1 reward-to-risk, profit factor = 1.33, risking 1% equity per trade.

 

Equity curve for 0.5-to-1 reward-to-risk, profit factor = 1.49, risking 1% equity per trade.

 

As you can see, increasing my profit factor actually harmed the growth of my equity. What's going on!?

 

I spent two days scratching my head, re-checking my maths and wondering what the hell happened. These are two versions of the same system, so the number of trades hasn't changed at all. The only difference between the two system versions was my R:R and nothing else. The system with the higher profit factor should be growing faster, not the other way around.

 

I began to examine my % equity risked per trade, and thought about the Kelly criterion. The Kelly criterion provides a mathematical method of finding your optimal risk per trade. I decided to find the optimal risk level for 2:1 and 0.5:1 R:R, which turned out to be 11% and 28% if I remember correctly.

 

Thus, when my risk was at 1% (when I graphed my equity curve), my risk level is more optimal for 2:1 R:R than 0.5:1 R:R. 1% is closer to 11% than it is to 28%, and thus my equity would grow faster using a R:R of 2:1 than 0.5:1, despite having a lower profit factor.

 

That was a startling discovery, and something I've never read in any trading book so far. It goes to show why a serious trader must do his own homework rather than rely on hearsay from experts or the internet. I'm now wondering if professional traders are aware of this paradox?

 

Now, this dilemma can be solved quite easily if you base your equity risk per trade on some derivative of the Kelly criterion rather than an arbitrary rule like "2%", which is espoused in some trading books. For example, you may risk 10% of Kelly, in which case I would risk 1.1% per trade if I'm using a 2:1 R:R, and 2.8% if I'm using 0.5 R:R. In this case, 0.5 R:R will build equity quicker and all is well.

 

Important lessons:

 

1. Do your own homework

2. Question EVERYTHING, even if it comes from Dr. Alexander Elder (i.e. the 2% rule)

3. Use context-sensitive, self-adjusting rules rather than hard, arbitrary rules