Portfolio Approach to Capital Management
Think Like a Portfolio Manager Act Like a Trader
“Think Like a Portfolio Manager Act Like a Trader” - is the watch word for me, having thought about it and developed a structure around it. The key difference is bridging the gap into trading.
The first stage of this process is to determine the investment horizon, I primarily use this to determine when I rebalance the portfolio/capital under management (“I will use portfolio and capital interchangeably”):
Weekly
Bi-Weekly
Monthly
Quarterly
Half-Year
Annually
Across these horizons, the manager aim to rebalance its book, by booking gains, reallocating capital across different asset class or security or generally just rebalancing the book.
For my trading, I primarily perform this action on a weekly and bi-weekly basis, and that is because of the type and duration of trades I run within the portfolio. However, for the MetaMacro portfolio I try to rebalance either Bi-Weekly or Monthly, if there is a need to.
Core Components
The key component of managing capital like a portfolio manager while executing as a trader are as follows:
Idea Generation
Risk Management
Position Sizing
Drawdown Management
Position Scaling
Handling Market Money
Securing Unrealized Gains
Idea Generation
The general notion here is to have a systematic process to generating ideas that cut across multiple asset class, this gives you a plethora of opportunities and doesn’t lock you into finding trades only within an asset class, as such, having a model or process that aids in generating ideas across the following asset class is a key process to capital management:
Equities
FX
Commodities
Bonds
So far, I majorly trade Equities, but I have shared couple of trades on Commodities, none on FX because the current market environment doesn’t offer a lot of swing trades, only intraday or weekly range positions.
Risk Management
This stage is a major component to adequately managing the trading book. I think risk is to be managed at two levels:
Risk on the Overall Portfolio over the Horizon
Unit Risk Per Trade/Investment
The first layer is to have a risk profile on the AUM(Capital/Asset under Management), by defining how much of the total portfolio is susceptible to loss:
Safe: 0.25% - 0.5%
Conservative: 0.5% - 1%
Mildly Aggressive: 1% - 2%
Aggressive: 2% - 4%
Extremely Aggressive: 4% - 10%
The second layer is a dependent on the first layer, which involves determining the unit risk per trade/investment, which is also a function of defining:
The maximum number of positions open over the horizon
Risk allocation per trade
Defining how many positions you intend to run simultaneously in the book is key, it also helps in placing a check on over-trading, once you can define this, you can allocate risk across the positions equally or on a weighted approach based on the level of confidence on each trade idea, but the cumulative value at risk should not be more than the overall portfolio risk value.
Position Sizing
Position sizing is also a function of the unit risk per trade, once you determine your risk, it also determines the size you intend to run in a position. Also note that a crucial component on the risk and position sizing is to also adequately define the R:R on the trade idea.
Drawdown Management
Once there is clarity on risk management protocols, a structure on managing the volatility on the principal is also key. Managing drawdown is also segmented into two components:
Managing Drawdown on Principal & Principal + Profit
Managing Drawdown on Equity
Managing drawdown on principal is simply setting a risk threshold on the deviation on your PnL relative to your starting capital, while managing drawdown on Principal + Profit (takes into account profit made). The following threshold could be set:
Conservative: 5% - 10%
Moderate: 10% - 20%
High: 20% - 30%
What this implies is that the manager would ensure the principal or principal + profit does not deviate negatively by a 10% drawdown level. This also feeds into the risk management protocol and overall helps in maintaining a smooth equity curve.
Furthermore, managing drawdown on equity, is more of managing your open PnL, this is a bit tricky, because if you are running multiple types/duration of trades, the drawdown profile is expected to be distinct, also, it brings to the forefront how to manage your stop and when to close positions.
I honestly, do not follow this rule head on, I am a bit flexible around here and the reason is that while systems can be built, they can sometimes be static. A case in point is based on experience, I could expect a decline in an open position for X reasons, but at the same time I expect a mean reversion post decline. The drawdown on equity model can’t fully account for that, hence why I think running a systematic + discretionary system is key.
Day Trades: 2% - 5%
Swing Trades: 5% - 10%
Position Trades: 10% - 15%
The key is to align risk management with the positions within the portfolio
Position Scaling
There are some trades where the manager could have immense confidence to play out, and this could prompt the need to increase size and maximize returns. I personally do not have the psychological fortitude to run a huge sizeable position from scratch, I prefer to scale in gradually. I think understanding your mental psyche here is key, there are things I can take in that others can’t and vice versa.
Nonetheless, I think the two approach that works at least for me in terms of position scaling are:
Full Size Entry
Gradual Scaling In
Both of which is a function of the following parameters:
Target Level on Trade
Start Level of the Move
From the above parameters, I grade the range into quadrants using the following Fib Parameters(basically percentages nothing esoteric lol):
Applied on a chart:
Essentially, what I aim to do is if I intend to execute a long $100k position, I could execute half of that size at 172 where I expect the move to start. Then I will scale in the rest of the positions as price trades above each discount quadrant levels and if I also think price action is supporting a long thesis. Overall, I would also aim to keep my WAC (Weighted Average Cost) below 50% of the range.
The structure I typically following in scaling in is as follows:
Initial Probe Entry: 30% of target size
Reaction Entry: 30% of target size
Momentum Confirmation: 20% of target size
Pyramiding on Strength: 20% of target size
I could also execute the momentum confirmation at 50% - 75% of the range so far my WAC stays below or at 50% of the range. In as much as there is a science to it, experience in scaling in, is still required - the Art, lol.
Handling Market Money
This section is entirely subjective, and is also a function of the goal/objective of the manager. Also, by market money I am referring to additional gains made on principal.
I also think this is a function of the investment horizon, I personally operate on a weekly and monthly horizon, but I could hold positions across a quarter. Once I have open profits I sometimes book all the gains to rebalance my book on a weekly basis, and this is because the frequency of trades I execute are short term in nature.
What typically could be done with the market money is to:
Withdraw X% of profits and invest in other asset classes (e.g., MMFs, T-Bills, Bonds, etc.) - basically running a broader portfolio and the trading account is a segment of that
Add the remaining balance to the principal, and reinvest then:
Allocate a portion of market money to risk additional trades (max 20%).
The first section is quite clear. The second section basically implies that while the overall portfolio risk is based on principal/starting capital, I could increase the principal by adding a % of market money made to that base to increase my risk, while also locking a portion of those gains.
There is no one way approach to this, its a function of your goal/objective of the portfolio.
Securing Unrealized Gains:
This section is also subjective, while a systematic process could be built around this to lock profits while allowing room for further gains through the following protocol:
At 15% of target gain: Book 10% of profits.
At 30% of target gain: Book 20% of profits.
At 45% of target gain: Book 30% of profits.
Leave the remaining 10% to run.
The downside to this approach is that on a net basis you make less money than when you hold the position for a full run. E.g if you had a position where you could have made $5k if held to full target, you would have made around $3k if you took partials, hence, you are essentially sacrificing $2k thereabout:
The advantage to this approach is that you get paid as you manage the trades, and transforming the unrealized/paper money into realized/market money.
The other approach to securing unrealized gains is by using trailing stops. The advantage of this is that if you don’t get scratched out pre-maturely you get to keep your $5k if price gets to the target. The cons on the other hand is that if price scratch you out pre-maturely you make less and you could beat yourself up if price eventually goes your way.
I alternate between the two approach. I rarely book partials, and I use trailing stops more, and if I do get scratched out and have a conviction that the move is still on, I establish a position in. This might not be the best approach for everyone, but the tenet is to have a broad idea and develop an approach that works for you.
In summary, I have excel model running for this, I think the article is self-explanatory to be able to build a basic model to manage the trading book. I hope you find this useful.
Cheers,