bail  himself  out.  Instead,  he  became  a  permanent  (somewhat  leg-endary) resident of Drawdownville. When I last checked, he’d built some lovelycondos on the hillside, which are now fully occupied by traders with similar, ifless dramatic, stories to tell.
Rufus’s  visit  to  the  Kingdom  took  a  very  different  course.  He,  too,  was  aworld-renowned  collector  and  held  many  of  the  same  types  of  treasures
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contained  in  the  satchel  of  his  boyhood  pal.  However,  most  of  us  who  knewthem both suspected that he had made better bargains for himself and had pur-chased  better-quality  stuff,  at  better  prices  from  the  same  merchants  patron-ized  by  Doofus.  Rufus  was  very  upset  at  the  notion  of  spending  one  minutemore in that sorrowful space than he had to. When he sensed his markets wereturning troubled, he began to sell everything. In fact, he was among the firstsellers of the stuff that Doofus was buying. As such, in retrospect, Rufus gotwhat were very handsome prices for his holdings. It took months; but by thetime he was finished lightening his load, he had plenty of cash to pay the exittoll. Later that fall, the winds started to blow favorably for Rufus and those ofhis ilk, and he ended up making more money than he ever imagined possible.Most of us have visited the Land of Drawdown and will do so again beforemuch  time  passes.  The  message  of  this  fable  is  clear:  If  you  wish  your  staythere to be a brief one, it pays to travel light.
DRAWDOWNS AND NETTING RISK
Another extremely critical implication of deep drawdowns, which appliesexclusively if you are working as part of a multistrategy trading team, isone referred to within the industry as netting risk. Specifically, netting riskis the contingent cost of having to pay out portfolio managers in a multi-strategy portfolio who are compensated on the basis of a percentage of therevenues  they  produce  from  an  overall  revenue  stream  that  has  beendiminished by the presence of unprofitable accounts. As any multistrategyfund manager will tell you, such netting expenses are pure poison to theprofitability  profile,  and  the  management  of  netting  risk  thus  becomes  acore focus of any rational multistrategy risk management model.
To illustrate why this is the case, consider a trading team of two indi-viduals funded by a third party under a scheme where each trader is paid25% of his or her profits. Now envision a scenario where one of the tradersmakes $1 million in a year, while the other loses $1 million. The net rev-enues  of  the  enterprise  are  precisely  zero,  but  this  does  not  obviate  thefunding entity’s responsibility to pay the profitable trader the $250,000 heearned  through  his  portfolio  management  efforts.  Undeniably,  the  condi-tion of expenses that cannot be offset by revenues is both bleak and unsus-tainable. From the point of view of the investors, the minimization of net-ting risk has to be a top priority.
If you are a member of a multistrategy trading team, you should rec-ognize that any negative returns you generate become contributing factorsto one of the most debilitating expenses that a trading firm can experience.The deeper you go into negative territory, the more acute is the problem
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your  situation  presents.  Therefore,  by  cutting  your  exposures  if  youraccount becomes even marginally unprofitable, you align your action withthe interest of your investors; and this, my friends, is a situation you shouldconstantly strive to create and maintain.
ASYMMETRIC PAYOFF FUNCTION
I’ll close my arguments regarding the need to reduce risk during drawdownby  discussing  a  widely  established  but  largely  underapplied  concept,which I will call (in part because this is the name that everyone uses) theasymmetric payoff function. Specifically, I refer to the reality that draw-down reduces not only investment returns but also the capital that is avail-able to deploy in the markets to recover the associated losses. Therefore,at  every  incremental  level  of  percentage-based  drawdown,  the  percentreturn needed to recover these losses increases at a geometric rate.
Perhaps the best way to explain this is through the use of an example.Let’s assume that I am a portfolio manager in charge of assets valued at $1million. If I lose $100,000 in the first month of operation, or 10%, not onlydo I have to make up this $100,000, but I have to do so with only $900,000of investment capital left to deploy in the markets to recover these losses.The $100,000 represents 11.1% of the $900,000 available to me, so I mustmake 11.1% in order to recover a 10% original loss in my account. More-over, this relationship will apply to a 10% drawdown, no matter whetherthe account in question contains $500 or $5 million.
As drawdown increases, so too does this disparity because a deepen-ing  loss  profile  contemporaneously  increases  the  size  of  the  recoveryneeded to get back to even while reducing the capital available to do so.Thus, a $250,000, or 25%, loss must be made up against $750,000 worth ofcapital, implying a 33% recover hurdle; and the trend continues from there.Indeed,  by  the  time  my  account  lost  $500,000,  or  50%,  my  recovery  taskwould involve making back $500,000 on the $500,000 of remaining capital,which translates into a 100% recovery hurdle.
The relationship between the percentage-based drawdown and associ-
ated recovery hurdle is specified below:
Y (cid:3) X/(1 (cid:4) X)
where X (cid:3) drawdown rate (in percentage terms)Y (cid:3) recovery hurdle (in percentage terms)
To further illustrate, look at Figure 5.2 and Table 5.1, which solve for
Recovery Hurdle (Y) in the equation at various levels of Drawdown (X).
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)
%
(
eldruHyrevoceR
300.00
280.00
260.00
240.00
220.00
200.00
180.00
160.00
140.00
120.00
100.00
80.00
60.00
40.00
20.00
0.00
5
10 15 20 25 30 35 40 45 50 55 60 65 70 75
 Drawdown Rate (%)
FIGURE 5.2 Drawdown rates and associated recovery hurdles.
TABLE 5.1
Drawdown Rates andAssociated RecoveryHurdles
Drawdown Rate
Recovery Hurdle
5%
5.3%
1015202530354045505560657075100
11.117.625.033.342.953.866.781.8100.0122.2150.0185.7233.3300.0(cid:10)
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I am particularly struck by the last line of the table, which would alsoapply to the graph if we could create a vertical access that reached up toinfinity.  That’s  right—if  you  lose  all  your  capital,  then  the  implied,  per-centage-based return you will need to recover these losses is infinite.
And now, my dearly beloved brothers and sisters, my sermon is over,and I step down from the pulpit on this topic. If you haven’t yet acquiredreligion  regarding  the  need  to  cut  capital  as  fortunes  move  against  you,then I fear you never may.
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CHAPTER  6
AdjustingThe RiskPortfolioManagementExposureInvestment(Rule 2)
He’s a worldwide traveler, he’s not like me or you,But he comes in mighty regular, for one who’s
passin’ thru,
That one came in his work clothes, he’s missed his
last bus home, 
He’s missed a hell of a lot of busses, for a man
who wants to roam, 
And you’ll never get to Rome, Son, And son this is Rule 2.
—Paul Heaton, Beautiful South,
“Liar’s Bar”
Iopen  this  chapter  by  offering  mad  props  hat  to  one  of  the  best  (and,
sadly, unrecognized, at least in the States) bands since the Beatles. Ifyou haven’t already done so, please do me a solid and check out Beau-tiful South. Feel free to blame me if this turns out badly; but in so doing,remember to temper justice with mercy, as I always have done with you(well, almost always—that time when you doubled down on your 10-year-note position in front of the monthly payrolls report, you deserved every-thing you got from me, and then some).
Throughout the preceding discussions, I have highlighted the criticalimportance of adjusting your exposure to account for your performancerelative  to  your  objectives,  for  drawdown  management,  and  for  otherrealities of the profit/loss (P/L) cycle. Call this Rule 1. Rule 2, with a grate-ful nod to my favorite musicians from Hull (along with the late great MickRonson),  is  that  effective  portfolio  management  demands  an  explicit
133
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understanding  of  the  alternatives  available  in  the  marketplace  to  bringabout such adjustment whenever the situation so demands. Your specificpath  for  risk  modification  will,  of  course,  depend  greatly  on  the  type  ofportfolio you are managing, as well as on factors such as prevailing mar-ket  conditions,  your  recent  fortunes  from  a  P/L  perspective,  and  other“situation-specific issues.” For instance, the steps that you would take tomodify risk on, say, a portfolio of U.S. government securities are by defi-nition  different  from  those  that  would  be  appropriate  for  a  portfolio  ofglobal  equities.  Similarly,  a  portfolio  of  derivatives  will  often  requireexposure adjustment measures that are different from those needed for aportfolio comprised of cash securities. Also, as implied earlier, risk adjust-ment to stem acute and abrupt losses will assume forms highly differentfrom  the  occasional  tweaks  to  your  exposure  that  you  might  wish  toundertake under happier circumstances.
With all of these qualifiers in mind, there is a common thread to thetypes  of  risk-adjustment  steps  that  you  can  take—irrespective  of  thecomposition  of  your  portfolio—to  meet  the  requirements  of  the  currentsituation you face. Some of these are described in this chapter.
SIZE OF INDIVIDUAL POSITIONS
I’ll  begin  by  stating  the  obvious:  Size  matters.  In  almost  all  cases,  thevolatility of your portfolio will vary directly with the size of your indi-vidual positions. In fact, in most cases (involving not only cash securitiesbut also derivatives), the relationship between position size and portfolioexposure will be linear. Absent compelling evidence to the contrary, it’s apretty  safe  bet  that  for  any  given  position  you  put  into  your  portfolio,  aposition twice that size will be twice as risky, whereas positions half thissize are likely to generate half the exposure.
There are a number of ways to make this concept work for you in themarkets. For example, you might either add or take away from your posi-tions in existing names so as to meet your appropriate risk profile. Or youmight  wish  to  adjust  your  position  size  only  on  incremental  trades.  Ineither case, you can take it on faith that one surefire way to manage yourexposure  is  to  assume  that  larger-size  positions  means  greater  volatility,and vice versa. Also bear in mind that while the relationship between posi-tion size and volatility will in most cases be linear, this linearity will breakdown at very large transactions sizes due to liquidity constraints. For port-folio managers with large pools of capital behind them, there are levels ofposition size where the risk profile changes dramatically. In cases whereyour trading size crosses these thresholds, you are likely to discover that a
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given percentage change in the sizing of your position may have a muchlarger impact on your overall portfolio exposure. Note, however, that youwill only manifest this additional portfolio volatility at the entry and exitpoints of the transaction. For the entire period in between, your P/L by def-inition will be a linear function of transaction size, where if position of sizeX generates $Y of volatility, those of 2X must generate $2Y; and so on. It istherefore important to remain mindful of the liquidity characteristics of themarkets in which you are trading and to map them carefully into your over-all risk management architecture. 
We will cover this topic in much greater detail in subsequent chapters.
DIRECTIONAL BIAS
While not applicable to all strategies in all markets, it is often a good ideato maintain a healthy mixture of long and short positions within a portfolio.This is particularly true in portfolios where the individual instruments con-tained therein tend to be highly correlated, such as those focused on equitysecurities or commodity futures. All other factors remaining equal (partic-ularly  those  tied  to  the  amount  of  leverage  in  the  portfolio),  a  balancedmixture  of  longs  and  shorts  is  a  less  risky  profile  than  one  in  which  allspeculations  are  pointed  in  the  same  market  direction.  For  example,  aportfolio that has a long position in corn and a short position in wheat islikely to be less risky, on a unit basis, than one that features dual longs orshorts in these same commodities. Similarly, an account that is long IBMand short Microsoft is likely to carry less exposure than one that containsthe same securities held on the same side of the market.
As portfolios scale up in size, the need to operate on both sides of agiven market becomes more pronounced, and I strongly urge this kind oftwo-sided market orientation as being one of the best means of maximiz-ing risk-adjusted profitability.
However, I should tell you that this challenge is, in my experience, oneof  the  most  difficult  in  advanced  portfolio  management.  This  is  becausemost  traders  and,  indeed,  most  markets  lend  themselves  more  directlytoward a single-sided market orientation. For example, it was plainly eas-ier to trade the long side of the stock market in the last half of the 1990s,first,  because  the  market  enjoyed  a  sustained  rally  for  the  entire  period;second,  because  the  equity  markets  are  structurally  organized  under  allmarket  conditions  to  favor  long  bets  through  such  mechanisms  as  the“uptick  rule”  for  short  sales,  the  rather  complicated  “borrowing-based”mechanics of short selling, the rules that compel large institutional portfoliosto operate exclusively on the long side of the market, and other factors. We
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must  bear  in  mind  that  short-selling  in  the  equities  markets  represents,when results are characterized in terms of their extremes, an asymmetricbet  under  which  gains  are  limited  by  the  fact  that  a  stock  cannot  priceitself at a value less than zero, while potential losses are, at least in theory,unlimited  in  nature,  as  there  is  no  upper  bound  to  the  value  at  which  asecurity can trade. By contrast, when I was in the futures markets, tradersconstantly told me how much easier it was to trade the short side of themarket, but then again no one ever accused this crowd of seeing any glassas being half full.
Though  it  can  be  difficult  both  psychologically  and  practically,  Ibelieve it is important, wherever possible, to practice the discipline of trad-ing on both sides of the markets, as the potential benefits from adoptingsuch  an  approach  far  outweigh  the  associated  annoyances.  In  the  firstplace, most providers of capital are more comfortable funding portfolioswith a dual market orientation than they are investing in portfolios wherethe risk is single-sided. I’m not sure that I agree with this philosophy onpure risk management grounds (one of my main tenets of risk control isthat a dollar of risk expressed one way is no more hazardous than a dollarof risk expressed another way), but the dual approach certainly mitigatescertain  event  risks—such  as  being  long  insurance  stocks  when  planescrash through buildings.
Beyond  this,  to  whatever  extent  that  your  portfolio  faces  externalvolatility constraints (and trust me, it does), a great way to manage yourassociated  exposure  is  to  achieve  some  balance  from  a  long/short  per-spective.  Long/short  portfolio  management  is  also  a  very  useful  tool  forrisk control in those cases when you are hoping to benefit from correctlyidentifying an information catalyst (e.g., a product announcement) but areunsure when the catalyst will take hold. In these situations, by utilizing abalanced portfolio approach, you will be much more able to maintain yourpositions during the adverse overall market conditions that may occur inthe period before your catalyst works its way into the pricing of the instru-ments you are targeting (more about this in a moment).
One  common  misconception  holds  that  in  order  to  be  a  successfullong/short player, it is necessary to operate profitably on both sides of themarket. While, all other things being equal, this is certainly a desirable out-come, I would argue that there are important benefits to be gained by oper-ating with a relatively balanced market-direction orientation even if you dono better than break even or lose modestly on the side where you are lesscomfortable operating. As indicated earlier, by doing so, you reduce yourexposure  to  broad-based  market  events,  such  as  crashes.  A  portfoliothat is entirely on one side of the market is exposed to the full fury of theseepisodes,  which,  as  we  have  already  discussed,  are  likely  to  cause  allsecurities  to  move  in  lockstep  with  one  another.  Perhaps  as  important,
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the presence of some well-adapted two-sided market exposure will greatlyenhance  your  ability  to  stay  with  your  best  ideas—across  all  marketcycles—and thus capitalize in those situations when you feel a high levelof conviction that a certain scenario will play out but less sure as to theprecise timing.
Let’s  take  a  moment  to  more  closely  examine  my  assertion  that  along/short  position  orientation  also  reduces  the  need  to  be  absolutelyaccurate in terms of market timing, shall we? In my opinion it is much eas-ier  to  make  money  by  trading  well-researched  ideas  in  individual  securi-ties—particularly those where you believe you have specific edge—than itis to predict whether the overall market is going up or down. If you makemore  narrowly  defined  positions  such  as  individual  equities  and  com-modities  your  money-making  focus,  my  experience  is  that  many  of  yourbest trades will be ones that you have put on somewhat more in advanceof the moment you would choose if you could trade through the “rearviewmirror.” In these cases, positions on the other side will protect you fromadverse movements in the overall market that may take place in advance ofthe event on which you are seeking to capitalize. I believe that it is criticalthat you do so because otherwise you run the considerable risk of beingblown  out  of  your  best  ideas  due  to  the  idiosyncrasies  of  the  macroeco-nomic environment; and if you routinely fall victim to this, my friends, youare doing nothing more than spinning your wheels.
At  the  end  of  the  day,  then,  unless  you  have  a  particularly  accuratecrystal ball, you’re likely to face a choice between the following outcomeswith respect to your best ideas: You’re going to be either early or late to theparty. Most traders have the experience and the savvy to recognize that thelatter alternative is unacceptable: Being late means missing the trade alto-gether. Ergo, for many of your key money-making transactions, it may benecessary  to  put  your  position  on  somewhat  in  advance  of  the  point  atwhich would have been ideal, from a risk/reward perspective, as viewedafter  the  fact.  The  immediate  attendant  consequences  are  that  you  aregoing to have to manage the volatility of the position along with the asso-ciated uncertainties as to the correctness of your opinion. If you can masterboth of these (and if you have, indeed, assessed the situation correctly),then to paraphrase Rudyard Kipling, yours will be the world and all that’sin it, and which is more, you’ll get paid, my son.
In  fact,  if  you  can  master  both  the  risk  control  and  the  “conviction-based” aspects of being early with your best ideas, you stand not only tomonetize them, but also to maximize them through the process of addingto your position at increasingly favorable price levels, an approach com-fortingly referred to in the financial markets as averaging. Of course, thisis a dangerous method, and one that is best practiced only by experiencedtraders who (1) are pretty damned certain that they are right about the idea
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in question, (2) have sufficient risk capital to stay the course, and (3) havethe  skill,  experience,  and  discipline  to  manage  the  process  effectively.  Idon’t want to put too fine a point on this and will stop short of suggestingthe averaging methodology to all but my most sophisticated and highly cre-dentialed readers. However, I do believe that the concept is illustrative ofthe manner in which the tool kit can work to the advantage of effective risktakers with a true market edge. Also, and perhaps more to the point, a two-sided  market  orientation  is,  at  minimum,  extremely  useful  to  anyoneattempting if not to average into a high-conviction position for which thepayoff timing is uncertain, then at least to maintain a core exposure. 
Let’s  consider  a  rather  crude  example.  I’ve  heard  (through  thegrapevine, of course) that you’ve fallen in love with a small-cap pharma-ceutical  company  called  XTC,  which  you  strongly  believe  is  about  toreceive approval from the Food and Drug Administration (FDA) for a drugthat  simultaneously  cures  depression  and  enhances  sexual  performance (I  know  this  is  far-fetched,  but  I’m  told  that  such  things  are,  at  least  intheory, possible). Because you are very thorough, you have carefully stud-ied the clinical trials, have read everything the FDA has said on the topic,have spoken to doctors who say that this is a great breakthrough, and haveanalyzed  the  financial  numbers  thoroughly.  Heck,  there  are  even  rumorsaround (though not started by me) that you were part of the clinical trialsand had a wonderful experience in the process. 
Unquestionably,  you’ve  done  your  homework  here,  and  it  appearsyou do indeed have an edge. But some smart money is betting that theFDA will send XTC back to the drawing board this very month. To makematters  worse,  as  of  late,  the  entire  small-cap  pharmaceutical  markethas been trading like some poorly fashioned version of Federico Fellini’s8 1⁄2.  Finally,  the  market  as  a  whole  is  very  volatile,  and  some  expertsbelieve  it  may  crash  at  any  time.  These  things  spook  you,  but  you’repretty sure that XTC will get its approval and that when it does the stockshould  double.  The  only  problem  is  that  you  don’t  know  when  theapproval will be forthcoming.
So how do you stay with this position long enough for the drug to getapproved  and  you  to  get  paid?  Well,  a  long/short  approach  will  certainlyhelp your cause. Perhaps you could pair this position off against a phar-maceutical stock that does not have such a catalyst. Walk a little ways fur-ther with me through this tortured example. Picture for yourself anothersmall-cap  pharma  company,  formed  out  of  the  merger  of  two  separatepharma  concerns,  the  Lucy  Companies  and  the  Skye  Corporation,  thatthen  acquired  a  third  enterprise,  Diamond  Pharmaceuticals,  to  form  theLucy, Skye, and Diamond Corporation. Its ticker symbol is LSD, and it isseeking regulatory approval for a drug that either enables people to fly ormakes  them  think  they  can  (I  forget  which).  Further  assume  that  your
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research—as  thorough  as  it  was  on  XTC  and  extending  back  severaldecades—indicates that the “federales” are a smidge less keen to approvethis particular product. Wouldn’t that make a swell pairs trade? If you soldshort some LSD and resisted the temptation to liquidate it prematurely, itmight enable you to hold your XTC through a full range of overall marketand  sector-specific  conditions  while  still  enabling  you  to  make  your  bigscore when XTC did win its approval.
By contrast, if you were holding both XTC and LSD on the long side,the consequences might be much more severe, matters might soon start toget  out  of  control,  and  there  are  circumstances  when  you  might  have  tobail out of both prematurely, which would not be good at all. If there is noLSD (or functional equivalent) available, you might prefer to sell short theDRG index—a sort of smorgasbord (or cocktail, if you prefer) of pharma-ceutical concerns that trades as a single security on the American StockExchange—to  achieve  the  same  ends.  Failing  this,  there’s  always  theopportunity to sell broad-based indexes, such as Standard & Poor’s (S&P)500 futures, which will protect your position in some, if not all, of the typesof situations that might otherwise force you to sell XTC before its time.
If you are able to hold XTC through the approval process, you can callit a victory—irrespective of whether you liquidate your LSD, DRG, or S&Psat a profit or at a loss. When viewed at a safely objective distance from theactual  portfolio  management  process,  it  is  easy  to  see  how  a  two-sidedmarket  orientation,  with  one  side  serving  largely  as  instruments  of  riskcontrol,  could  offer  better  risk-adjusted  returns  than  one  that  focusedexclus