My drawdown should not exceed my "uncle point"
Just found this which might be good for your risk management:
http://www.seykota.com/tribe/risk/index.htm
Looks like he's doing fixed fractional money management without resorting to formulae.
Thanks for the link again. Here Seykota says something I've been thinking about:
The Uncle Point
From the standpoint of a diversified portfolio, the individual component instruments subsume into the overall performance. The performance of the fund, then becomes the focus of attention, for the risk manager and for the customers of the fund. The fund performance, then becomes subject to the same kinds of feelings, attitudes and management approaches that investors apply to individual stocks.
In particular, one of the most important, and perhaps under-acknowledged dimensions of fund management is the UNCLE POINT or the amount of draw down that provokes a loss of confidence in either the investors or the fund management. If either the investors or the managers become demoralized and withdraw from the enterprise, then the fund dies. Since the circumstances surrounding the Uncle Point are generally disheartening, it seems to receive, unfortunately, little attention in the literature.
In particular, at the initial point of sale of the fund, the Uncle Point typically receives little mention, aside from the requisite and rather obscure notice in associated regulatory documentation. This is unfortunate, since a mismatch in the understanding of the Uncle Point between the investors and the management can lead to one or the other giving up, just when the other most needs reassurance and reinforcement of commitment.
In times of stress, investors and managers do not access obscure legal agreements, they access their primal gut feelings. This is particularly important in high-performance, high-volatility trading where draw downs are a frequent aspect of the enterprise.
Without conscious agreement on an Uncle Point, risk managers typically must assume, by default to safety, that the Uncle Point is rather close and so they seek ways to keep the volatility low. As we have seen above, safe, low volatility systems rarely provide the highest returns. Still, the pressures and tensions from the default expectations of low-volatility performance create a demand for measurements to detect and penalize volatility.
I've got systems that - more or less - can be money/risk managed to produce either of these situations:
1) in a year I'll get 11 months with a 20% gain, and one month with a 20% loss
2) in a year I'll get 11 months with a 50% gain, and one month with a 50% loss
Now why am I choosing right now option # 1 rather than the more convenient option # 2 ?
Because of my uncle point: when do I chicken out? At a drawdown of 2000 dollars. In detail because of this:
1) A 50% drawdown is something I am expecting, forecasting, but, like in all trading, it is not something I am 100% positive about. If this were the case, I would borrow 10 million dollars and invest it tomorrow. But the problem is that there's always a chance that the expected 50% drawdown will turn into a 90% drawdown, which basically means blowing out my account.
2) I am borrowing my capital (10k loan from bank) so that makes me even more insecure. One thing is to lose 10k of my own money, which I don't need and I consider peanuts. Another thing is to be indebted with my bank for 10k. The consequence is that as soon as I see a drawdown of more than 2k I already run into my "uncle point", and start having second thoughts about my systems, and fearing they might not work anymore, and start messing with them to make them more secure, which is not always good.
The bottom line is that one should not use his drawdown as a method to choose his money/risk management settings, but his uncle point.
My capital could take a drawdown of 4k without having any problems, but as soon as I'll lose 2k, I'll start panicking, so I should set my money management parameters for an expected drawdown of 2k, even if this means making 20% a month rather than 40% a month.
You see, what happens when I think I can take a drawdown of 4k is that I allow my CL systems to trade. Then, once I incur two straight losses on them, amounting to a total of 3k, I start panicking and disable them. So there's no point in even starting to trade the CL systems, because, even though my capital might be able to withstand their drawdown, my confidence in my systems and my fear of losing the money from the loan do not allow me to mentally withstand such a drawdown.
So here I am, with about 30 good systems, 20 awesome systems, but only trading 10 systems, mostly because I don't trust my systems and because my capital is from a loan.
Obviously, once I'll have a capital of 20k, all this will change, because my buffer capital will increase. I won't repay the debt, because that'd leave me with no money, but I'll be less afraid of drawdown and invest in more systems.
Right now I am 5k from being screwed, and that 5k cannot be the allowed drawdown. Once I'll be at 20k, I'll be more than 10k from being screwed, so I can allow my drawdown to be as large as 5k, which means my monthly gain will also be as large as 5k (because of how my systems' specific performance, not to say it applies to all systems).
[...]
Later edit:
Until now I've been ignoring altogether my uncle point and this has caused failure and disruption of my automated trading. I'd come home and cry "uncle! uncle!", halt my systems, try to make my money back... now I understand that my drawdown and whether my capital can take it is almost useless if my uncle point is lower than my drawdown. My money management should always make sure that my potential drawdown doesn't exceed my uncle point. If it does, it means I am being reckless, and it means I might be put into a situation where I'll have to stop trading - not because I run out of capital but because I run out of confidence.