The Geometry of Leverage Space Portfolios 335
The first, and perhaps most important, thing to realize about reallo-
cation, can be seen in Figure 10.1. Note the arrow in the figure, which is
identified as thatTwhere Equation (10.09) is equal. This amount of time,T,
is critical. If you reallocate beforeT, you are doing yourself harm in trading
the dynamic, rather than the static, fractionalf.
The next critical thing to realize about reallocation is that you have
some control over the maximum drawdown in terms of percentage equity
retracements. Notice that you are trading the active portion of an account
as though it were an account of exactly that size, full out at the optimal
levels. Since you should expect to see nearly 100% equity retracements
when trading at the full optimalflevels, you should expect to see 100% of
the active equity portion wiped out at any one time.
Further, many traders who have been using the fractional dynamicf
approach over the last couple of years relate what appears to be a very good
rule of thumb:Set your initial active equity at one half of the maximum
drawdown you can tolerate.Thus, if you can take up to a 20% drawdown,
set your initial active equity at 10% (however, if the account is profitable and
your active equity begins to exceed 20%, you are very susceptible to seeing
drawdowns in excess of 20%).
There is a more accurate implementation of this very notion. Notice, that
for portfolios, you must use the sum of allfin determining exposure. That
is, you must sum thefvalues up across the components. This is important
in that, suppose you have a portfolio of three components withfvalues
determined, respectively, of .5, .7, and .69. The total of these is 1.89. That
is thefyou are working with in the portfolio, as a whole. Now, if each of
these components saw the worst-case scenario manifest, the account would
see a 189% drawdown on active equity! When working with portfolios, you
should be very careful to be ever-vigilant for such an event, and to bear this
in mind when determining initial active equity allocations.
The third important notion about reallocation pertains to the concept
of portfolio insurance and its relationship to optimalf.
Portfolio Insurance and Optimalf
Assume for a moment that you are managing a stock fund. Figure 10.2 de-
picts a typical portfolio insurance strategy, also known as dynamic hedging.
The floor in this example is the current portfolio value of 100 (dollars per
share). The typical portfolio will follow the equity market one for one. This
is represented by the unbroken line. The insured portfolio is depicted by
the dotted line. You will note that the dotted line is below the unbroken