The Geometry of Leverage Space Portfolios 359
Drawdown Management and the New Framework
THE NEW FRAMEWORK
Drawdowns occur from one of three means. The first of these, the most
common, is a cataclysmic loss on one trade. I started in this business as
a margin clerk where my job was to oversee hundreds of accounts. I have
worked as a programmer and consultant to many of the largest traders in
the world. I have been trading and working around the trading arena for my
entire adult life, often with a bird’s-eye view of the way people operate in
and around the markets. I have witnessed many people being obliterated
over the course of a single trade. I have plenty of firsthand experience in
getting destroyed on a single trade as well.
The common denominator of every single occasion when this has
happened has been a lack of liquidity in the market.The importance of
liquidity cannot be overemphasized. Liquidity is not something I have been
able to quantify. It isn’t simply a function of open interest and volume.
Further, liquidity need not dry up for long periods of time in order to do
tremendous harm. The U.S. Treasury Bond futures were the most liquid
contract in the world in 1987. Yet, that, too, was a very arid place for a few
days in October of 1987. You must be ever vigilant regarding liquidity.
The second way people experience great drawdowns is the common,
yet even more tragic, means of not knowing their position until the market
has moved ferociously against them. This is tragic because, in all cases, this
can be avoided. Yet it is a common occurrence. You must always know your
position in every market.
The third cause of drawdowns is the most feared, although the conse-
quences are the same as with the first two causes. This type of drawdown
is characterized by a protracted losing streak, maybe with some occasional
winning trades interspersed between many losers. This is the type of draw-
down most traders live in eternal fear of. It is this type of drawdown that
makes systems traders question whether or not their systems are still work-
ing. However, this is exactly the type of drawdown that can be managed and
greatly buffered through the new framework.
The new framework in asset allocation concerns itself with growth
optimality. However, the money management community, as a general rule,
holds growth optimality as a secondary concern. The primary concern for
the money management community iscapital preservation.
This is true not only of money managers, but of most investors as well.
Capital preservation is predicated upon reducing drawdowns. The new
framework presented allows us for the first time to reduce the activity of
drawdown minimization to a mathematical exercise. This is one of the many
fortuitous consequences of—and the great irony of—the new framework.