• How risk management works in The Portfolio

    This article was published on November 23, 2015 as a part of the Portfolio Management Articles.

    I would like to review here how risk is managed in the Portfolio. This is key to the success of the Portfolio and THE reason why in the past two years, the max drawdown has never been higher than 4%.

    Risk management is key to the success of the Portfolio because you can outperform the market only if you concentrate your trades in a few positions. The more positions you manage, the more diversified and hence the less chance you will have to outperform the general market. This is the reason I manage only five positions: to be able to outperform the markets. But this means it is essential to follow these positions very closely and to manage both the positions and the portfolio risk.

    Let's review the positions of the Portfolio. Note that I have made some change in the Max DD calculation (in orange).

    1. The five day probability to hit the stop.

    This is calculated by looking at the distance between the last price close and the stop. The system looks at how many times in the past 150 days the stock has covered that distance within five days. We want this probability to be below 50%. If it is higher, then we need to closely watch the stock or trim the position.

    2. The Max Loss

    This simply indicates the loss on the position if the stop is hit.
    For AEO, since the stop has been raised above the entry price, the loss is 0%.

    3. The Total Portfolio Risk

    For each position we calculate the position's risk to the Portfolio. Since we only follow 5 positions, each position carries a risk that is calculated by the 5D probability to hit the stop, multiplied by the Max Loss and divided by 5. This number is also weighted by the position size. A 50% position size carries half less risk to the portfolio.

    The total of -0.29% indicates the statistical potential loss to the portfolio for the next five days. This figure should never be lower than -1%.

    4. The Maximum Portfolio Drawdown

    Here, we calculate how much the portfolio will lose if the position hits the stop, starting from the last close. For example, the last close of AEO was $15.75. This means that if the stop of $14.9 is reached, the drawdown on the position will be 5.4%. Since the position size is only 50%, the DD carried to the portfolio is 5.4% * 50% divided by 5 positions = -0.54%

    You will note that the Short Trades MAX DD of -1.22% is the sum of the Pink cells, while the Long Trades Max DD is the sum of the Green cells. The difference between these two Figures is -0.14% (in Orange).

    This -0.14% information tells us that the potential gains for this Portfolio is very limited, simply because the max DD is too low. The Max DD can be viewed as "The skin I have in the game." The Portfolio is extremely well balanced here, with just the same risk on both sides of the market.

    This situation is intentional because I will be away early in the days of Monday and Tuesday.

    By the way, I updated the portfolio stats here:


    Let's now review the trades of last Friday.

    First, I closed the AMZN Long, when we dipped below a support level. Later in the day, AMZN pushed higher and it closed up more than 1% for the day. Do I regret that I exited AMZN. Of course I regret it, but I cannot do anything about it. This is a past decision. I can only reflect and say "I should/would..."

    I opened a 1/2 long IMPV and was hoping that the price would dip lower, but it did not.

    Volume on the Bounce at 11:00 was very strong too, which should have given me a clue to increase the position right there.

    I also took a short GBX. I almost increased the short position when we bounced early in the day. My expected price was not reached.

    The most controversial trade might be the short biotech position that I took at the end of the day.

    I opened that position because IBB started to be under pressure AND because I wanted to end the day with a balanced portfolio.

    Note that LABU is a Triple Long Biotech ETF. In previous trades, I had used BIS (Double short biotech) to trade IBB on the short side. LABU is however twice more liquid than BIS and because it is leveraged, going short a leveraged long ETF puts the decay on my side.

    Note that LABU is being sold right now. The Natural stop for that trade would be above the recent high, but this is 14% away, which is too far for me. The actual stop is already more than 7% away. Hence, I only carry half a position here.

    Note that LABU is a triple leveraged Long S&P500 Biotech fund (XBI ETF), while IBB is a Nasdaq Biotech fund. The IBB MF does not entirely correspond to the XBI fund.

    The trade ideas for Monday are shown below.
    The pink ideas are Breakdown/Breakout on volume.