loss orders find that their actual liquidation prices are at lev-els much worse than those implied in the instructions to their brokers. Ina common, worst-case scenario, many a trader has confronted a situationwhere an adverse market move has triggered a stop order, which in turnhas caused the broker to liquidate the position at a price that was not onlymuch worse than the trader anticipated, but was actually the worst priceof the day—the market subsequently reverted to levels much more favor-able to the trader’s original position. Very few other events are more frus-trating to market participants.
I  nevertheless  recommend  the  use  of  stops  for  individual  investors.The situations where a stop-loss causes problems are reasonably rare andtend  to  happen  most  routinely  during  periods  of  acute  market  volatility.
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Under  most  market  circumstances,  your  stop-loss  orders  ought  to  workout  just  fine.  Moreover,  when  you  do  see  the  market  moving  sharplyagainst  you,  you  can  always  manage  the  problems  associated  with  stop-loss  orders  by  simply  canceling  them  and  replacing  them  with  outrightliquidation instructions at prevailing market prices.
The objective is to make sure that the bottom 10% of your trades don’ttake away from the core benefits you are almost certain to derive at theopposite end of your P/L distribution. A sound risk control program thatfeatures active position management is the critical component.
Trading  Psychology. As  a  final  point  regarding  the  90/10  rule,  Iencourage you to use this knowledge to fortify your patience. In my expe-rience, the typical portfolio manager may go through weeks, if not months,of difficulties in the markets before he or she ultimately gets paid. In theseintervals, your thoughts may lean toward the radical as you assume thatthe core fundamentals of your model have broken down and that drasticchanges are needed. In fact, the 90/10 rule instructs us otherwise. It’s use-ful, during these moments, to remember that even the best traders are sub-ject to profitability concentration and, as such, often have extended peri-ods of underperformance. As long as you are managing your risk properlyduring these intervals, it is likely that what you are experiencing is not afundamental, negative shift in your portfolio management prospects, butrather  the  ebb  and  flow  of  the  marketplace,  which,  as  a  rule,  does  notaward large profit opportunities to market participants on a routine, con-tinuous basis. 
Time  is  on  your  side  here,  provided  that  you  can  effectively  controlyour  exposures.  Over  the  longer  haul,  the  market  is  likely  to  offer  youample opportunities to fill that 10% bucket to the brim. By contrast, if youradically change your strategy every time you go through an extended dryspell,  it’s  difficult  to  imagine  how  you  will  ever  achieve  the  type  of  flowthat is conducive to your best trading intervals.
PUTTING IT ALL TOGETHER
The material I have presented in this chapter is a lot to digest. In an effortto help you visualize the overall transactions-level statistical analysis andsee how we might interpret the results, please refer to the sample portfolioshown in Figure 7.1.
We  have  discussed  many  of  these  statistics  throughout  this  chapter,and hopefully they make some sense to you. This particular account hap-pens to be one with pretty strong statistical profile, so there’s not much forthe likes of me to complain about. Over the course of the full year that is
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Capital Invested $
3,000,000
3,000,000
3,000,000
7/1/02–9/30/02
10/1/02–12/31/02
1/1/02–12/31/02
Return StatsTotal P/L $Average Profit/Trade $Average Profit/Trade %Profit/Loss — Long Side $Profit/Loss — Short Side $Average P/L — Long SideAverage P/L — Short Side
Transaction Stats# of Positions Taken# of Daily Transactions% Winners% Winners — Long Side% Winners — Short SideAverage Holding Period — DaysAverage Holding Period — Long SideAverage Holding Period — Short Side
CorrelationsCorrelation to Account ActivityCorrelation to Account VolatilityCorrelation to Capital InvestedCorrelation to Net Market ValueCorrelation to S&P 500Correlation to Nasdaq CompCorrelation to Treasury Note
RatiosAccuracy (Win/Loss) RatioImpact RatioPerformance Ratio% P/L reflected in top 10% of trades% P/L reflected in bottom  10% of trades
P/L by Security/AssetFinancialEnergyIndustrialTechnologyUtilitiesIndexOther
361,39411,293.56
0.38%234,906126,48812,3639,730
19,000730.77
0.02%11,2107,790534708
619,0005 5,895.24
0.20%377,590241,4105,7216,190
320.5053%65%35%4
37
0.580.17
0.710.15(0.43)0.17(0.09)
0.531.770.94103%59%
(7,228)72,27961,437(25,298)126,488
89,26444,451
260.4149%59%41%3
25
0.670.23
0.590.03(0.37)0.060.21
0.491.030.50105%71%
(1,045)3,4205,5103804,370
3,6482,717
1050.4254%61%39%3
25
0.630.21
0.650.09(0.12)0.210.15
0.541.700.92105%64%
(30,950)111,420120,705(18,570)219,745
145,46571,185
FIGURE 7.1 Transactions-level-statistics.
covered  by  the  analysis  (I  have  also  provided  quarterly  statistics  for  thetwo  most  recent  quarters),  a  number  of  positives  present  themselves.There is a healthy balance between long- and short-side P/L, a positive cor-relation  to  such  factors  as  account  activity  and  capital  invested,  and  theubiquitous P/L concentration in the top tier of trading activity—all of whichI have argued is consistent with a high-quality portfolio management effort.
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Daily P/L
150,000
100,000
50,000
0
(50,000)
(100,000)
TRADING RISK
Cumulative P/L
800,000
700,000
600,000
500,000
400,000
300,000
200,000
100,000
0
(150,000)
1 1/1 4/2 0 0 21 0/3 1/2 0 0 21 2/1 3/2 0 0 29/5/2 0 0 29/1 9/2 0 0 26/1 1/2 0 0 21 0/1 7/2 0 0 21 1/2 9/2 0 0 23/1 5/2 0 0 24/1 5/2 0 0 21/2/2 0 0 21 0/3/2 0 0 25/1 3/2 0 0 23/1/2 0 0 28/7/2 0 0 25/2 8/2 0 0 21/3 1/2 0 0 21 2/3 0/2 0 0 28/2 1/2 0 0 21/1 6/2 0 0 27/1 0/2 0 0 22/1 4/2 0 0 26/2 5/2 0 0 27/2 4/2 0 0 24/2 9/2 0 0 24/1/2 0 0 2
Daily P/L
Cumulative P/L
60
50
40
30
20
10
0
2
−80or <
51
43 43
35
22
18
2
0
5
3
1
10
8
2 3 2 1 1
−79to −70
−69to −60
−59to −50
−49to −40
−39to −30
−29to −20
−19to −10
−9to −1
0
to 
9
10to
19
20to
29
30to
39
40to
49
50to
59
60to
69
70to
79
80to
89
>90
210
Buying Power ($)
3,000,000
3,000,000
3,000,000
7/1/02–9/30/02
10/1/02–12/31/02
1/1/02–12/31/02
Return StatsTotal P/L  $Total Return(% Buy. Pwr.)Average P/L (Daily $)Average P/L (Daily %)Sharpe Ratio (Daily)
Volatility StatsStd. Dev. (Daily P/L $)Std. Dev. (Daily % of Buy. Pwr.)Maximum (Daily $)Minimum (Daily $)Maximum / 1 Std.Dev. P/ LMinimum / 1 Std.Dev. P/LDownside Deviation ($)
Daily P/L StatsNumber of DaysPercentage of Up DaysPercentage of Down DaysAverage Up DayAverage Down DayWin / Loss Ratio
361,39412.05%5,6470.16%0.20
19,0000.63%2970.00%0.00
619,00020.63%2,4560.07%0.10
28,0900.82%90,962(60,587)3.24(2.16)14,130
6450%50%27,122(15,828)1.71
32,5500.91%82,000(122,000)2.52(3.75)25,452
6450%50%24,063(23,469)1.03
25,3490.75%90,962(122,000)3.59(4.81)17,498
25254%46%19,439(17,139)1.13
Capital Invested $
3,000,000
3,000,000
3,000,000
7/1/02–9/30/02
10/1/02–12/31/02
1/1/02–12/31/02
Return StatsTotal P/L $Average Profit/Trade $Average Profit/Trade %Profit/Loss — Long Side $Profit/Loss — Short Side $Average P/L — Long SideAverage P/L — Short Side
Transaction Stats# of Positions Taken# of Daily Transactions% Winners% Winners — Long Side% Winners — Short SideAverage Holding Period — DaysAverage Holding Period — Long SideAverage Holding Period — Short Side
CorrelationsCorrelation to Account ActivityCorrelation to Account VolatilityCorrelation to Capital InvestedCorrelation to Net Market ValueCorrelation to S&P 500Correlation to Nasdaq CompCorrelation to Treasury Note
RatiosAccuracy (Win/Loss) RatioImpact RatioPerformance Ratio% P/L reflected in top 10% of trades% P/L reflected in bottom  10% of trades
P/L by Security/AssetFinancialEnergyIndustrialTechnologyUtilitiesIndexOther
361,39411,293.56
0.38%234,906126,48812,3639,730
320.5053%65%35%4
37
0.580.17
0.710.15(0.43)0.17(0.09)
0.531.770.94103%59%
(7,228)72,27961,437(25,298)126,488
89,26444,451
19,000730.77
0.02%11,2107,790534708
260.4149%59%41%3
25
0.670.23
0.590.03(0.37)0.060.21
0.491.030.50105%71%
(1,045)3,4205,5103804,370
3,6482,717
619,0005,895.24
0.20%377,590241,4105,7216,190
1050.4254%61%39%3
25
0.630.21
0.650.09(0.12)0.210.15
0.541.700.92105%64%
(30,950)111,420120,705(18,570)219,745
145,46571,185
FIGURE 7.2 Consolidated report.
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In addition, the win/loss ratio hovers at just above 50% over the period inquestion; and the impact ratio is an impressive 1.77, indicating that whilethe trades in the account liquidate to winners at little better than 50%, theaccount takes in $1.77 or so of profit for every $1.00 it gives back in losses.The attendant performance ratio of 0.94 is, according to our measures, apretty high-quality result—substantially above the 0.5 that we have arguedis a benchmark minimum threshold for sustained profitability.
If  we  really  want  to  be  ambitious,  we  can  combine  the  transactions-level analysis covered in this chapter with the time series review discussedin Chapter 3 in order to evaluate account performance in a truly holisticmanner. In fact, let’s do it now, for the combined benefit of yuks and eru-dition (see Figure 7.2).
Paints a nice picture, now, doesn’t it? There’s nothing like attacking thesame problem from two different angles to give perspective, I always say.Are there any areas for improvement? To be perfectly honest, there’s not alot of negativity to hang our hats on here. Probably we’d like a benchmarkcorrelation  to  the  S&P  500  to  be  a  bit  lower  in  absolute  value  termsbecause we can’t be entirely sure as to how this account will perform onall tapes. He had a nasty little drawdown around Thanksgiving but recov-ered quite nicely and finished near his highs. Overall, I’d say our friend isdoing just fine. 
There  are  virtually  unlimited  paths  to  explore  in  transactions-levelanalysis, and the ideas presented in this chapter are simply the ones that Ifind  offer  the  best  cross  section  of  being  relatively  intuitive  while  alsolending  themselves  to  straightforward  statistical  analysis.  Hopefully,  atminimum I have convinced you that your market success is less a functionof  external  and  uncontrollable  forces  than  you  previously  may  havebelieved. Performance is the direct result of a number of routine decision-making activities that can be broken down and analyzed from an efficiencyperspective. While even the best traders and investors are going to needthe markets to smile on them from time to time, my experience has shownthat  the  manner  in  which  they  adapt  their  activities  to  changing  marketconditions is a much more critical driver of success than are the evolvingdynamics of the markets themselves. Our goal here, minimally speaking,was to open your mind to that concept and, beyond that, to offer you somesimple  methodologies  that  will  enable  you  to  act  on  that  concept  in  aconstructive fashion.
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CHAPTER  8
The RiskBringin’ It on Home
Factum est illud, fieri infectum non potest.(Done is done, it cannot be made undone.)
—Plautus
Improbable as it may seem, we are now entering the last leg of our journey
together. It’s not that I have run out of interesting insights to share, butrather  that  I’m  certain  you’ve  reached  the  point  where  you  can  endurethem no longer. Those of you who have hung with me this far should be com-mended. You are most certainly going places if not because these methodshave helped you reach your objectives as a portfolio manager, then, at mini-mum,  because  you  have  demonstrated  the  stamina  and  endurance  to  bearuntold hardships in pursuit of a greater good. This is a powerful resource, andI urge you to use it judiciously, as the forces of darkness are ever among us.The  mechanisms  and  methodologies  we  have  discussed  in  this  bookare designed to help you identify the important subtexts of your portfoliomanagement activities so that inefficiencies can be quickly isolated and, ifnot corrected, at least minimized in terms of their profit/loss (P/L) impact.Most certainly, the metrics I have presented will have varying utility to you.I hope that you will come away from this book with these general concepts:
• Portfolio management success and failure can be viewed as the cumu-lative  result  of  a  large  number  of  decision-making  activities  that  fitbroadly into such categories as position selection, execution manage-ment, and risk control.
• It  is  possible  to  measure  your  success  at  these  individual  decision-making levels in such a way as to obtain a more precise understandingof what is working well in your program and what isn’t.
213
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• When things begin to go bad, if you can identify weaknesses in specificareas, they will be much easier to correct than it would be to improveunder the (likely erroneous) assumption that either the markets haveturned bad on you for all time or that your portfolio management skillshave permanently deteriorated.
• These  methodologies  will  enable  you  to  identify  the  sets  of  marketconditions  that  are  most  conducive  to  your  success  so  that  you  canmaximize your activity during these intervals and reduce it when theconditions that prevail are less ideal.
• For  all  of  these  reasons,  most  traders,  investors,  and  portfolio  man-agers have a much greater ability to master their destinies in the mar-kets than they generally believe they have.
It  has  been  my  primary  and  perhaps  exclusive  objective  throughoutthis book to help you unleash the power of these concepts from inside you.In the process, I have borrowed a large number of basic principals fromthe field of statistics and superimposed them on a trading/investing frame-work. It has not been my intent to turn you into an egghead like me; rather,I simply want to provide you with the means of better understanding whyyour performance varies across external and decision-based factors underwhich you operate, such that you can bring out the best in yourself underany given set of external circumstances.
With this in mind, I’d like to use what remaining attention you are will-ing to devote to these pages to revisit some core concepts of portfolio man-agement of which you can make more precise use through the filter of ourstatistical tool kit. In many cases you will have heard these notions before.Indeed, some of them are as old as civilization itself (which arguably beganand was cultivated for no other purpose than the creation of the marketmechanisms in which you are now deeply immersed). I hope to show youthat many of them can have new meaning when viewed through the per-spective of the analytical approaches I have described. The statistical toolsthat have been our core focus will both reinforce these concepts and pro-vide you with mechanisms to evaluate the extent to which you have beengoverned by them, as I believe you should be, whether you choose to takeany other elements of my advice or not.
MAKE A PLAN AND STICK TO IT
I come across countless instances (and suspect that the true number is inthe millions) where traders and investors are active in the markets but haveno  clear  idea  what  they  are  trying  to  accomplish  in  them  or  don’t  know
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whether the strategy they are using is even remotely designed to achievetheir objectives. Some are in it because they love the action; others becausethey  think  it  is  the  thing  to  do.  I  occasionally  also  run  into  some  markettypes whose main objective is actually to make money in an efficient man-ner.  However,  it  is  my  observation  that  this  class  of  market  participantscomprises  a  rather  meager  minority  and  doesn’t  necessarily  draw  dispro-portionately from the pool of humankind whose trading activities representtheir vocation in life. Indeed, I know many professional portfolio managerswho have failed to produce so much as a clue as to what exactly they areattempting to capture through their trading and investment affairs, despitethe fact that they are often managing huge sums of money and are rou-tinely paid millions of dollars for their expertise.
I’m hard-pressed to comprehend how these folks succeed at the task ofcapital  preservation  (much  less  accumulation)  over  the  long  haul.  Plainlyspeaking, unless you have a pretty good idea of what you’re doing in the mar-kets  to  make  money,  you’re  unlikely  to  continue  making  money  for  verylong. What is worse, without a well-defined strategy, if you happen to enterthe markets in a timely fashion with an approach that affords you some ini-tial profitability, you run the risk of gaining a false sense of confidence aboutyour  own  trading  mastery  that  can  be  very  hazardous  to  your  financialhealth when the theme that has been working runs out of steam.
It is therefore critical that you design your trading program to capturesomething  very  specific  in  the  marketplace  that  is  consistent  with  yourcore skill sets, capital availability, risk tolerance, and trading environment.Just as you should avoid trades at sizes that would wipe you out if you’rewrong by small amounts, so should you steer away from strategies that areincompatible  with  your  lifestyle,  resources,  and  other  factors  that  mayindirectly affect performance.
Doctors with full patient loads and surgical schedules shouldn’t try today trade, for example; they simply don’t have time for it. Similarly, tradersshould stay away from options and complex derivatives unless they have abasic  understanding  of  the  pricing  dynamics  (or,  ideally,  the  underlyingmathematics) and unless they have the desktop tools needed to calculatethe  pricing  on  the  instruments  that  they  hold.  I’m  constantly  amazed  athow often and how obscenely basic rudiments of common sense such asthese are violated in the markets. Benjamins, sweet Benjamins, fly from usin  the  process,  presumably  into  the  arms  of  other  Lotharios  with  moreforesight,  and  almost  certainly  never  to  return.  So  wasteful,  so  unneces-sary, and above all, so preventable. 
Further, I routinely make the acquaintance of traders and investors ofall levels of sophistication who enter into strategies for which they lack theunderstanding and/or the resources to master. To me, this type of thing isthe financial equivalent of scuba diving without the proper equipment or
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operating  a  chain  saw  blindfolded.  No  matter  what  your  basic  skill  set,you’re bound to get hurt in the end.
Now that I’ve beat you to death with the notion that you need a strat-egy,  I’d  be  remiss  if  I  didn’t  offer  some  insight  as  to  how  to  devise  one.While there are a number of ways to attack this, you may wish to frame theproblem in terms of the following four questions:
1. What markets will I trade?
2. How much capital do I have to work with?
3. How much am I willing to lose before throwing in the towel?
4. What type of infrastructure do I need to operate efficiently?
In terms of the markets you select, a large part of your choice shouldbe driven by the identification of exploitable inefficiencies in some portionof the market economy. I would argue that unless you can pinpoint somesystemic inefficiency in the markets and can further devise a trading strat-egy to capture these inconsistencies, your success as a portfolio managerwill  be  driven  almost  exclusively  by  good  fortune,  which  quite  clearly  isoutside the realm of what you can control.
The process of trading with the benefit of an exploitable inefficiencyis known in the parlance of the markets as trading with an edge, and wewill explore this concept in greater detail shortly. Unless you can con-vince  yourself,  with  objectivity  and  conviction,  that  your  trading  pro-gram  has  an  edge,  you  shouldn’t  be  risking  a  great  deal  of  capital,  ifindeed  any  at  all.  However,  once  you  are  satisfied  that  your  programdoes  provide  you  with  an  opportunity  to  monetize  on  a  nonrandombasis, the next questions you will want to ask yourself pertain directlyto capital:
• How much can I put to work?• How much am I willing to risk losing?
The answers should be based on considerations very specific to yourpersonal situation (whether the capital is provided by you or an externalfunding  source)  but  also  on  the  characteristics  of  the  markets  you  aretrading. For example, you don’t want to be trading futures contracts if youcan barely scrape together the money to post margin. By the same token,you should avoid resorting to indirect funding sources to finance your trad-ing activities, and you don’t want to put yourself in a position where thereis  a  meaningful  possibility  of  losing  more  than  you  can  afford  to  dropacross your entire program. The tools in this book will help you managethe process effectively, but these tools will be of minimal value to you if
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you don’