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.

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