Saturday, May 19, 2018

How Big Should the Trading Program Be?

At the moment I am still in the experimental phase of the trading program. A 1 contract S&P or NASDAQ position either adds or subtracts about 0.1 beta to the portfolio. So if the beta of our portfolio to the market was 1.0, trading modifies this to 0.9 when short to 1.1 when long. My goal is to be able to hedge our portfolio against a market crash. That means we need to subtract up to 1 full beta from the portfolio. On the long side we then would double exposure. This means that the trading program needs eventually to be 10 times the size it is now. Using 3 times leverage on the cash in the trading account that implies allocating 25% of assets to trading. My existing allocation has 25% of assets allocated to managed futures. This total could be allocated between my own trading and "outside managers" such as Winton and meet this goal.

Why 3 times leverage? Simulation shows that about a 12% drawdown is possible. Remember that we use stops and or hedging to limit possible daily losses. So this drawdown means a string of large losses. With 3 times leverage that would wipe out 1/3 of the trading account. More than that and it will reduce the earning potential of the account too much going forward, I think. And be way too scary.

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