most acute dangers associated with increasing your stop-out  level  during  a  rough  period  is  that,  once  having  done  so,  the  next
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thought that will invariably enter your mind will be to increase your day-to-day  risk  levels—perhaps  by  ratcheting  up  the  size  of  your  trades,expanding your loss-taking capacity on individual transactions, and othersimilar  tactics.  Once  this  has  occurred,  you  have  effectively  removed  acritical and in some cases final element of risk control. Your increased risktaking is intertwined with impatience, with a desire to make back all thatyou have lost in a brief time period. It’s like a swimmer who gets caught inan outward tide, abandons the steady pace that would actually move himcloser to safety, and instead wastes his much-needed energy on mad, fren-zied strokes toward the shoreline. The effort in both cases is futile.
For  professional/institutional  traders  who  increase  risk  after  a  largedrawdown, all I can say is, “Shame on you.” You’re playing with fire, and Ican all but assure you that everyone, with the possible exception of your-self,  knows  it.  This  biggest  element  of  the  danger  you’re  creating  is  thatyour desire to quickly make back your losses in almost all cases runs indirect conflict with the best interests of the owners of your portfolio. Fromtheir point of view, you now represent someone who (1) is not going to getpaid unless fortunes take a dramatic turn for the better; (2) may view hisor her job to be in jeopardy; and, as a result, (3) is no worse off (and mayin fact be better off) taking even bigger risks than the ones that helped digthe  hole  in  the  first  place.  For  most  institutions,  you  are  not  their  solesource  of  trading  revenue,  and  every  new  dollar  of  loss  is  an  additionalburden to them. They may, as a result, act much more decisively to cut offyour  funding  supply  than  might  be  hoped  for  if  you  demonstrate  a  clearcommitment to operate within your loss limits.
For  these  reasons,  one  of  my  core  risk  management  concepts  is  theneed  to  set  your  risk  levels  as  a  function  of  your  P/L  performance.  Thismeans  that  the  time  to  increase  your  market  exposure  is  after  you  haveaccumulated some positive returns for the cycle. The more important con-verse is that it is critical that you reduce your exposure in periods of neg-ative  performance.  My  decades-long  experience  in  the  field  of  risk  man-agement  tells  me  that  no  risk-control  concept  is  more  important.  Forreasons stated earlier and for others discussed throughout this book, trad-ing accounts that don’t learn to operate at lower levels of risk—both dur-ing and immediately after significant drawdowns—eventually trade them-selves out of existence. This may not happen the first time, or the secondtime, or the third. However, statistically speaking, your blowout is a virtualinevitability; it’s simply a matter of time. 
Conversely, if you can learn to manage your risk as a function of yourperformance  for  the  period,  you  stand  every  chance  of  withstanding  theslings and arrows of outrageous market fortune and of being around withrisk  capital  to  burn  when  markets  take  a  turn  for  the  better  (which  I’mpretty sure they will). However, actually doing this is more difficult than it
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sounds, first and foremost because it often has important financial impli-cations. By committing to play small until you make back what you havelost, you implicitly submit to an investment of time, perhaps a considerableamount of time, depending on factors such as market conditions and thedepth of the hole you’ve dug for yourself, which will be hard to endure ina number of ways. First, whether you trade for your own account or man-age money for some other entity, the time and energy you spend recoupingyour  losses  will  inevitably  divert  resources  away  from  generating  theincome that presumably is the main objective of your trading program. Ona related note, such a program will force you either to miss certain of yourbest market opportunities or, at best, to capture them at lower orders ofmagnitude, relative to what would be possible under your normal risk-tak-ing capacity. 
Second, you should be aware that this process is often worse from apsychological perspective than it is as measured in terms of economics. Ican’t begin to tell you how many traders whine to me that they are missingopportunities  of  a  lifetime  because  they  occurred  during  a  period  wherepreceding  losses  had  constrained  risk-taking  capacity.  Take  it  from  me;this is mostly in your mind. If you stick to your program, you may live toenjoy many, many more once-in-a-lifetime opportunities. If you break therules you have set for yourself, these opportunities may never come yourway again.
Finally, I want to make clear that hitting your stop-out level—particu-larly  if  you  have  followed  some  of  the  good  disciplines  I  have  recom-mended—needn’t mean that your trading career is over. It does, however,mean  that  you  must  close  out  all  open  positions  in  your  portfolio  andreassess your situation. Do so as quickly, as efficiently, and as profitably asyou can—a task that will have been rendered much easier if you have fol-lowed the risk-reduction advice presented here. Once this process is com-plete, take some time off—at least a week, but longer if it feels right. Thefirst thing you should do is get as far away from the markets and from trad-ing as you possibly can. Go on a trip, preferably out of the country (or atleast out of the time zone). Train for a marathon and then run in it. Get yourband back together and record some new tracks. Just do something that isnot trade related.
THE BEACH
In Pete Townsend / The Who’s “Quadrophenia,” the last, desperate flip-outof the main character takes place on the beach: a place of sanctuary forthis  troubled  soul,  tragic  ending  notwithstanding.  In  the  business  of
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trading, we like to send people to the beach at an earlier stage of a cycle ofdementia.  If  the  trip  is  executed  in  a  timely  and  efficient  manner,  theresults can be just as dramatic and entirely more positive. 
What exactly is implied, in trader parlance, by the term “going to thebeach”?  Stated  simply,  it  describes  a  process  whereby,  in  the  wake  of  astring  of  losses,  a  given  portfolio  manager  liquidates  his  or  her  portfolioand  walks  away  from  the  markets  for  a  time.  Specific  application  varieshere, but the rule of thumb is that the more significant the portfolio event,the  longer  and  more  “market  remote”  the  trip  to  the  beach  should  be.Oftentimes, a trader will suffer a temporary and entirely identifiable break-down in decision making, which doesn’t carry career-threatening P/L con-sequences  but  which  may  have  more  significant  implications  until  thetrader can straighten himself or herself out. In these cases, I have foundthat  a  couple  of  weeks  off,  with  the  trader  completely  unburdened  fromthe  responsibility  of  portfolio  management,  can  work  wonders.  Under  amore  acute  set  of  loss  circumstances,  mostly  involving  loss  levels  thatthreaten  the  existing  trading  franchise,  it  may  be  necessary  for  the  indi-vidual in question to hit the beach for a period of up to several months.
The  idea,  in  any  event,  is  to  come  back  with  a  fresh  outlook  on  themarkets.  Sometimes  this  works;  sometimes  it  doesn’t.  In  the  case  ofJimmy, the Who’s multipersonalitied protagonist, he ended up stranded, ona rock, in the rain, wasted and without sanctuary, presumably forever. Still,on the whole, I don’t think that the beach is the worst place in the worldfor traders to visit now and again. Just remember to bring your sunblockand maybe an umbrella (just in case). 
Let’s look at a case study of a trader who needed a trip to the beach inthe  worst  way  and  didn’t  get  one—until . . . the  high  tide  nearly  washedhim away.
SQUEEZING O.J.
I know a guy who clawed his way out of the back office of a major trading firmand onto to the trading desk through a combination of talent, diligence, per-sistence,  and  good  fortune.  This  doesn’t  happen  very  often;  and  as  a  result,everyone—most notably the colleagues he left behind in operations—was root-ing  for  him.  He  happened  to  trade  agricultural  commodities,  including  sucharcane products as orange juice (OJ). He also happened to be black. I only men-tion this because I’ve decided to call him O.J. here. For a time, he put up someHeisman-like numbers—albeit on small size—in his trading account. He had akeen eye for spotting the parts of the market that were moving, which is essen-tial for someone who trades actively. Surrounded by a group of very clever andmore seasoned market participants and operating in a space that was, during
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his good years, very active, O.J. caught the eye of the entire management team,who thought of him as having real potential. 
But O.J. had big plans and already thought of himself as a Hall of Famer.At the tail end of a two-year successful run, he demanded a huge increase incapital,  going  so  far  as  to  propose  a  contractual  schedule,  which  wouldincrease the money he was managing 10-fold in a matter of months, and pre-sented it to his management as something of an ultimatum. Alas, several mem-bers of his company’s management team were agnostic on his trading skills.In particular, they felt he was much more the beneficiary of good markets andproximity to talented portfolio managers than he was an architect of his ownsuccess.  They  determined  that  his  ambitions  were  significantly  ahead  of  hisdevelopment schedule and left his capital right where it was. 
This  threw  O.J.  into  a  rage.  Perhaps  understandably  (though,  I  canassure you, incorrectly), he felt there was an element of prejudice in the deci-sion-making process. And, as often occurs in situations like this, his deteri-orating  mental  state  coincided  with  something  of  a  sea  change  in  his  mar-kets. Just at a point when his motivations shifted away from profitability andtoward a desire to show the firm that they were wrong, the strategy on whichhe relied most strongly began to lose its effectiveness. On second thought,this  is  much  too  polite  a  characterization:  O.J.’s  trades  started  to  sucklemons.
It  didn’t  take  long  before  O.J.’s  market  struggles  and  personal  unhappi-ness began to wreak havoc with his decision making. This breakdown took sev-eral forms. First, he started to double down on positions working against him.Then,  as  risk  management  issues  started  to  take  a  higher  priority,  he  trans-ferred almost his entire portfolio into long options strategies, thinking this wasthe  best  way  to  limit  his  exposures.  Soon,  he  began  complaining  that  theoptions  were  throwing  off  losses  that  were  inconsistent  with  the  manner  inwhich risks were represented in the trading systems—systems that during hissuccess met his needs to his full satisfaction. When he tried to hedge out hisoptions-based exposures, it only exacerbated his losses.
With the benefit of 20/20 hindsight, it is easy to see that this would havebeen  a  perfect  moment  for  a  trip  to  the  beach.  When  his  management  sug-gested this to him, he reacted badly. No, he said, he was determined to tradehis way out of his problems. He further indicated that he had spent a great dealof  time  and  energy  analyzing  his  problems  and,  based  on  this  analysis,  wasconvinced not only that the hard times were behind him, but also that a wealthof market opportunities just on the horizon made this the worst possible timeto liquidate his portfolio. Not wanting to undermine his confidence unduly, hismanagement reluctantly went along with the plan.
As O.J’s losses deepened, so did his conviction as to the correctness of hiscore  ideas.  To  control  risks,  he  liquidated  all  but  a  couple  of  commodityfutures  positions  that  represented  the  centerpieces  of  his  market  viewpoint:
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short positions in winter wheat and orange juice. Other markets were actuallyacting much more favorably for his strategy, but he didn’t care. He was surewheat and OJ were going to break and looked to this happy event as one thatwould not only bail out his P/L, but also provide him with sweet vindication.And  you  know  what?  These  markets  indeed  started  to  break.  Exhausted  butconfident, O.J. took a week off.
The  coupe  de  grace  came  toward  the  end  of  this  holiday,  just  as  the  OJcontract headed into its delivery cycle. First came the news, in the form of asternly worded letter from the New York Orange Juice Exchange, that the firmhad exceeded speculative delivery limits for its lead-month orange juice con-tract. You see, as most agricultural futures contracts are liquidated before theybecome deliverable, the exchanges allow traders to hold much bigger positionsizes prior to the point when delivery occurs than they do after the process ofphysical transfer has begun. Professional traders know this and have an obli-gation to adjust their positions accordingly. O.J.’s failure to make this adjust-ment  was  therefore  a  very  amateurish  error  on  his  part.  Moreover,  it  was  amajor  embarrassment  to  the  firm,  which  was  a  significant  sponsor  of  theOrange Juice Exchange and which had, up to that point, an unblemished recordof compliance with agricultural delivery procedures.
However, the biggest impact of this mistake was not the public relationsproblem, but a direct, market-based one. Deliverable positions are publishedto  market  participants,  and  everyone  could  see  that  someone  was  out  there,obligated to make delivery on a whole lot of orange juice. Insiders knew thatdeliverable  supplies  were  tight.  At  the  risk  of  heaping  one  bad  pun  uponanother, O.J. was about to be squeezed.
Speculative  buyers  smelled  blood  in  the  water  and  bid  up  the  price  ofdelivery-month  OJ  like  it  was  a  cure  for  male-pattern  baldness.  At  this  point,O.J. and his firm had two choices: either buy back those futures contracts in ahurry,  or  start  squeezing  oranges  itself.  Problem  was,  there  were  almost  nosellers in the futures market. O.J. (whose holiday, it must be told, ended earlyand abruptly) was able to buy his way out of his position only at much higherprices and after a prolonged and agonizing fortnight that comprised the entiredelivery cycle. When the dust had settled, he had lost nearly everything he hadmade in the markets during his magnificent earlier two-year run.
O.J. is out of the markets now. Rumor has it, he devotes most of his time
to golf.
Once you are back from the beach, take a cold hard look at what wentwrong. Start with a review of the metrics presented in this book: Are yourlosses based on correlations to underlying markets that went against you oron poor selection decisions? Did the losses occur in a handful of unfortu-nate  trades,  or  are  they  spread  widely  across  your  account?  How  do  the
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losses distribute themselves over time? In what ways are the numbers yougenerate different from those tied to your profitable intervals? Do your bestto answer each of these and related questions as objectively as possible.
Now  go  speak  to  people  whom  you  trust  within  your  market  sector.What is their view of what went wrong? Do they feel that your problem iscorrectable, or should you go on to something else?
Note that it may be useful to put all of this down in writing and submityour  synopsis  to  an  outside  party  for  review.  However,  whether  youchoose to make this a formal process, if you take the time and the effort togo through this exercise, you will place yourself in the best possible posi-tion to objectively assess your situation and to formulate your best strat-egy for attacking the markets in the future. 
If you are hip to the “Chestnut Mare,” you already know that the herodid catch his horse but was only able to ride it for a short while. I alwaysthought it significant that he fell off after seeing what turned out to be hisreflection in the water.
Nevertheless, I think on the whole that he found the experience satis-factory and went on to write one righteous song about it. And, as he says,he’ll be back—and so should you. Be smart the next time around, and usewhatever lessons you can from previous experience. This ought to pointyou  toward  a  simple  trading  program  that  features  moderate  risk  levelsand  will  allow  you  to  reorient  yourself  toward  the  market  in  a  way  thatmaximizes  your  prospects  for  success.  Even  if  the  answer  you  come  upwith is that you want to suspend your trading indefinitely (and often this isa very viable alternative), you will save yourself a great deal of pain andaggravation if you’ve followed the steps set forth in this chapter, relative toan approach where you simply dive back in, experience either the favor orthe wrath of the markets, and never contemplate the reasons why.
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CHAPTER  3
UnderstandingThe Riskthe Profit/LossManagementPatterns overInvestmentTime
We will be geared toward the average, rather thanthe exceptional.
—Gerald “Little Milton” Bostock
(aka Ian Anderson)“Thick as a Brick”
By now, you have established two critical components of an informed
performance  management  effort:  You’ve  (1)  picked  one  or  moretime intervals for evaluation and (2) set some rational series of per-formance objectives. Without going any further down the analytical path,you are now ahead of many of your peers because you are in a position tomeasure your results in ways that are consistent with your environmentsand constraints. It’s now time to take the next step and perform a statisti-cal evaluation of your returns, which, if executed in an efficient manner,will provide critical insights into the true characteristics of your success(or lack thereof) and which will be crucial to your efforts to achieve max-imum returns over an extended time horizon and across the full range ofmarket conditions.
These  statistics  will  not  provide  you  with  perfect  insight  into  thedynamics of your portfolio. Rather, they will offer you clues as to the com-binations  of  dependent  and  independent  variables  that  are  tied  mostclosely to your relative success. Moreover, there is considerable hazard intaking  too  literal  an  interpretation  of  the  statistics  you  calculate.  Forexample, you may find yourself negatively correlated with a benchmarkindex,  such  as  the  Standard  &  Poor’s  (S&P)  500,  and  form  the  logicalhypothesis that you are making most of your money on the short side. Infact, as we will see, it is entirely possible to be negatively correlated with
37
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the  S&P  500  without  ever  having  sold  short  a  single  security  over  theperiod of analysis. 
You  must  therefore  gird  yourself  against  the  temptation  to  under-take  aggressive  modifications  of  your  trading  behavior  on  the  basisof a direct  interpretation  of  a  single  statistic  or  even  a  combination  ofquantitative  indicators.  Trading  is  a  very  complex  process  thatinvolves many interdependencies that do not lend themselves to evalua-tion  on  an  isolated,  case-by-case  basis.  Indeed,  by  changing  individualaspects of your trading behavior, you are likely to impact several otheraspects  in  such  a  way  that  is  far  from  guaranteed  to  generate  a  netbenefit.
Instead, you should use these statistics as a general diagnostic in yourportfolio management tool kit, which, like various doctor’s tools (stetho-scope,  thermometer,  blood  pressure  cuff,  etc.)  will  give  you  more  con-crete indications about what’s going on in your portfolio than you couldpossibly identify through pure qualitative observation. In going down thispath, we may find areas for potential improvement; but we won’t respondwith  any  rash  adjustments  because  changing  one  factor  can  have  unin-tended consequences, upsetting a hard-won, delicate balance that is thehallmark of most successful portfolios and doing more overall harm thangood.  As  a  result,  we’re  going  to  be  careful  before  drawing  any  conclu-sions that actually imply the need for intervention; and if we do decide tochange  things,  it  is  going  to  be  based  on  controlled  experiments,  usingfinite amounts of capital, and on an evaluation of results that draws fromthe same statistical tool kit that we used to identify the problems in thefirst place.
Hopefully,  this  sounds  encouraging.  But  I  urge  you  to  withhold  finaljudgment  until  we  begin  to  address  specific  trading  patterns  and  associ-ated response alternatives. In the meantime, we can start by defining thetypes of statistical information that are useful in obtaining a better under-standing of those characteristics of your portfolio that may be having thegreatest impact on your performance.
One last point before we begin: Some of the stuff contained in this nextsection  is  positively  trivial  for  anyone  with  even  a  rudimentary  under-standing  of  mathematics  and  statistics.  If  this  applies  to  you,  you  won’tlearn much here and may wonder why it is included in a book geared topeople  who  may  use these  tools  routinely  in  their  day-to-day  activities.However, in my experience, I’ve run into enough people who don’t have afirm  understanding  of  this  material  (both  personal  account  traders  andprofessionals)  that  I  decided  to  err  on  the  side  of  overexplanation.  Tothose  who  do  know  this  material,  a  quick  review  certainly  won’t  hurtbefore we get to the really good stuff.
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AND NOW TO STATISTICS, BUT FIRST A WORD(OR MORE) ABOUT TIME SERIES CONSTRUCTION
In order to effectively evaluate your performance, it is going to be neces-sary to establish a benchmark unit block for this analysis. Here, there areseveral alternatives, but the first and perhaps the most important of theseis time. In  fact,  I’d  go  so  far  as  to  say  that  without  looking  at  your  per-formance  in  “time  series”  units,  your  chances  of  deriving  much  benefitfrom  these  materials  is  severely  diminished.  Understanding  the  ins  andouts of time series analysis is so important that, as boring as it may be, wehave to cover it first (if only to get it out of the way). If you are familiarwith this territory, feel free to skip; but think carefully before you just blowpast it, as it may ultimately be worthy of your attention. 
Time  is  one  of  the  most  critical  scarce  resources  that  comprise  theRisk Management Investment (in some ways, it’s the most important), andthe  manner  in  which  your  market  performance  distributes  itself  acrosstime is, therefore, an essential framework through which to evaluate yoursuccess.
In  framing  our  time  series  analysis,  we’ll  focus  on  two  different  andimportant questions: (1) What is an appropriate span of time over whichto evaluate your performance? (2) What unit of time represents the mostappropriate data point? Here, I will argue that there are a number of alter-native time spans that you should analyze and that the time span (as wellas availability) of data should determine the unit size. By comparing andcontrasting your performance over different time spans, you stand to gainsignificant insights into what is driving its underlying account economics. In order to define the analytical problem with maximum precision, we
must first make the distinction between the two measures: 
1. Time Unit (or Increment): The size of a given profit/loss (P/L) obser-vation, as measured in increments of time. This figure can typically beexpressed in increments as small as one day or as large as a year, witheach  having  different  analytical  implications,  as  defined  in  later  chap-ters. Although it is theoretically possible to measure time in units muchsmaller than a single day, for reasons explained later we find that theremay be hazard in doing so, most notably the potential mismatches in themanner in which certain securities are priced intraday.
2. Time Span (or Interval): The entire period of evaluation, comprisedof individual time units, across which we wish to calculate basic infor-mation. Typical time spans can range from one week to a year, againwith different implications in each case.
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The decision I ask you to consider, therefore, is which time units toreview over what time spans. It may be useful to think of your alternativesin this regard as being summarized in the following matrix:
Weekly
Monthly
Quarterly
Annual
Time SSpan
TimeUnitT
Daily
Weekly
Monthly
Quarterly
Annual
Now  let’s  look  at  the  implications  of  each  alternative  in  terms  of  its
implications for time series analysis.
Time Units
Daily. This is the level of P/L unit analysis that I believe offers the mostcomprehensive set of information, largely because it is the most granular.For any given time span, a daily P/L series will yield the largest number ofobservations, which in turn will offer the highest level of statistical  sig-nificance. Though more robust definitions are certainly available, it maybe useful to think of statistical significance as the presence of a sufficientnumber of data points to ensure the stability of a given statistical calcula-tion.  This  concept,  which  is  critical  to the  objective  of  maximizing  theinterpretation accuracy of the data I will ask you to analyze, is addressedin detail in the body of the text. I recommend that, if at all possible, tradersbuild and maintain a time series of their daily market performance. Thisdata will serve as the primary building block in determining such criticalstatistical  benchmarks  as  correlations  to  outside  markets,  P/L  volatility,and drawdown characteristics.
For  some  traders  operating  in  certain  markets,  it  may  be  difficult  oreven impossible to calculate daily return statistics. Apart from other obsta-cles,  such  as  availability  and  accuracy  of  data,  the  instruments  they  aretrading  may  simply  not  price  every  day.  However,  I  encourage  portfolio
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managers to strive as best they can under these circumstances to estimatethe impact of market changes on their overall P/L on a daily basis. This fig