Last time we discussed the theory of climbing back out of a dip having avoided the bulk of the drawdown that might have otherwise been experienced.  During the recovery the aim is to increase size quickly in order to further capitalise on our change of fortune.  This was the simple model we were working from:

This time I want to discuss some of the practical difficulties we have to face when translating this theory into reality.

The main problem we have is that the simple clean curve we see in theory is a very crude approximation for the noisy line that we will actually experience in real life.  The second problem is that we need to be able to identify when the bottom of the dip has actually been formed in order for us to be able to move from reducing size to increasing size.  If we can find a way to deal with these two factors, we can come surprisingly close to matching our theoretical model.

Identifying your bottom!

Let’s deal with identifying the bottom first as this is the first thing that we have to concern ourselves with in practice.  In our model you should recall that during our first recovery month we are trading exactly the unit size as dictated by our capital preservation plan in the previous month.  In other words we don’t have to worry about whether we have turned the corner or not during the month in which we actually do turn the corner.  We simply know when this has happened by virtue of having a profitable month.

Next we have to deal with the noise issue.  What if our profitable month was just a blip, just a bit of noise on a continuing downward path?  That’s a serious concern in the real world that we have to be prepared to deal with if necessary and here is how to do it.

When you had your first profitable month you were trading with a tiny monthly risk of just 1.05% of capital, having cut back from a starting point of 8% at the previous equity high.  The line in the sand is the equity low made at the close of the previous month and this must be defended at all costs.

The rule is simple – as you pull away from this line it becomes increasingly safe to increase trade size.  However should you head back down towards it again you have to be prepared to cut size again were you to reach that equity low again.  At the equity low, you immediately reset your trade size to whatever you were using during the 1.05% month, and reapply your capital preservation plan from that point going further down below that line.  The safety net provided by the capital preservation plan takes precedence over everything else.

Increasing size

OK, so that deals with the worst possible outcome, which in reality is not bad at all.  So let’s now consider how we operate once we do pull away from that equity low.  Our objective is to double our size each month as we climb back out of the hole, until our original unit size is reached, equating to 8% monthly risk in this example.

So after the first profitable month (the 1.05% month), you could just move straight up to 2.11% which is next step up on the theoretical model.  However this is where our practical noise problem has to be considered.  In simple terms you have a month’s worth of profit under your belt so far and this is the buffer between where you start the next month and that line in the sand.  If you double your unit size in one hit, you effectively halve the size of that buffer.

Is that what you really want to do in practice?  Probably not.  As you pull further and further away from the line in the sand, in becomes easier and easier to increase size and the additional risk becomes proportionately less.  But in these early stages of recovery we need to be more guarded in practice than in theory.  So here’s what we can do…

Split the month into 4 or 5 weeks and increase a little bit after each profitable week.  This is a tactic that will effectively preserve that buffer you have whilst achieving the goal of increasing size.  So for example if your previous size was say 6 contracts, don’t go straight up to 12 on the first day of the month, but maybe go to 8. As long as your first week at 8 contracts ends in profit go up to 10 for week 2.  If your first week wasn’t profitable be pleased that you were trading 8 lots and not 12s and stick at 8 for the next week.

If week 1 was positive, go up to 10 in week 2.  If week 3 is positive move up to 12 and maintain that for the remainder of the month.  At the end of the month you ended at the desired size but avoided risking your buffer unduly.  So yes in practice doing this costs you a few more days than in the noise free theoretical model.  But so what?  You just endured a 6 month drawdown and pulling away from that line in the sand as smoothly as possible is far more valuable than a few extra days in the overall scheme of things.

Now you have 2 months of buffer profits under your belt and you are well on your way to recovery.  Until you make new equity highs always keep that line in the sand in place and be prepared to act accordingly.

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Copyright © Simon Townshend Ltd 2010, all rights reserved

The markets appear to have stabilised after a most challenging period.  For the first time in quite some while we seem to be seeing a period of more normal volatility.  That is not to say that conditions are perfect as clearly they aren’t.  However most markets are at least tradable once again.  So we are in with a fighting chance of fulfilling our objectives.

I have spoken at length in the past about managing your equity curve when entering a period of drawdown.  There is no doubt that recent months will have lead the majority of traders into some sort of drawdown.  Now things are starting to look a little brighter, it is time to think about how we manage our way back out of a drawdown.

To some traders, myself included, managing your way into and back out of a drawdown can be one of the most powerful tools in the armoury, so this is a subject worthy of significant personal study.  In this first article I want to cover the core principles of this technique and then next time I will expand upon this and discuss how we put the theory into practice.

Going Into The Hole

Let’s start at the beginning, with your capital preservation plan.  The purpose of this is to ensure you retain the majority of your capital – however long and however bad a drawdown period you have to endure.  Everyone has his or her own version of this, but I am going to use the simple model I gave you in Golden Rule #3.  In this we have (a) a maximum allowable loss limit per month and (b) loss levels at which we cut our unit size by 1/3^rd each time a drawdown level is reached:

The main point here is that even with a somewhat conservative rate of cutting back the unit size, you still have 80% of your capital at the end of an astonishingly bad period.  You would also carry on cutting back if it went on further.  If you never recovered at all you would still have ¾ of your capital intact by the time you retired!  So don’t underestimate the importance of this.

Climbing Back Out

Once the tide has turned you then start to build your size back up.  However if you reinstate size more aggressively you can accelerate the recovery back to equity highs by taking fuller advantage of the upturn.

In the following model I show the effect of the same capital preservation plan which risks a maximum monthly loss of 8% initially and reducing by 1/3^rd when going down.  When climbing back out this plan doubles the unit size after each successive profitable month, until full size is restored.  In this way it takes 6 months of reducing from full size down to a very small unit size, but only 3 months to build back up to full size which is then maintained in the final 3 months.  The result is the red line.

In contrast the blue line shows the impact of sticking with a fixed unit size throughout but still using a maximum monthly loss limit – so this line is a simple 8% loss each month on the way down and a fixed 8% monthly gain when going back up.

So after 6 bad months and 6 good months the linear plan gets right back to where it started, after enduring a gut wrenching 48% drawdown and with no certainty that it couldn’t actually continue going down to zero if the second six months also turned out to be losers!

Whereas our planned and managed approach not only recovers fully but even generates a 10% profit on what is a very bad year.  But most important of all its drawdown is a much more tolerable 22%, plus the mathematical certainty that it actually cannot fall very much lower than that were the second six months to also be complete losers.

I don’t know about you, but I know exactly which one I prefer!  Yes there are several practical difficulties in implementing this, which prevent a simple theory working perfectly in real life.  But we can come surprisingly close with the right tactical approach and that is what I will cover next time.

Disclaimer, risk warning and copyright notice apply to all articles published on this site.

Copyright © Simon Townshend Ltd 2010, all rights reserved