Portfolio Draw Downs

“Not even God could sink this ship” – Quote regarding the Titantic

That was the belief at that time of the almighty Titantic.  We all know what happened…the best built ship in the world sunk.  Oh yeah, we watched Leonardo hang out with the “high class” before paying the bill in the end.

Trading lesson: no matter how confident we are in our trading strategy, there will come a time when our trades are tested.  The market will either sink our trade or we will find a way to stay afloat.  It is that simple.  Draw downs are unavoidable.  That takes us to August 24th.  For those who were trading during that recent time, you remember.  The S&P 500 futures opened up “lock limit down” after falling 100 points pre-open.  It was ugly.

For those who want to know what it felt like, here’s a one-minute video of an Angry Trader:

Angry Trader video:  https://www.youtube.com/watch?v=OVytw0DlkfE

Personally, what did I learn through that experience?  A lot.  At that time I was trading Strangles, Straddles and John Locke’s M3 trade.  The below simulated trades demonstrate how my trades handled the Aug. 24th market drop:

Trade setups:
All trades entered on Aug. 4th at 45DTE
Max loss: 10% or 2x credit received
Max gain: 10%

1. Strangle, 4 contracts, 1SD Delta, Credit Received: $5,178
2. Straddle, 1 contract, Credit Received: $5,050
3. M3, 10 contract butterfly, Profit Goal: $5,000 or Max Loss: $5,000

Results:

1. Strangle: Sunk – Exited on Aug. 20th at a loss of $5,178 or 10.4%*
2. Straddle: Sunk – Exited on Aug. 24th at a loss of $7,350 or 14.7%
3. M3: Stayed alive – Maintained trade on Aug.24th with a loss of $3,482 or 6.9%**

(*) The Strangle loss if kept on like the other two trades until Aug. 24th would have amounted to -$21, 886.  Ouch!
(**) The M3 was eventually closed out for breakeven having never hit the 10% max loss rule.

Ever since I closed out my Strangles and Straddles, I’ve moved the majority of my portfolio into the M3 trade.  The main reason deals with draw downs.  The M3 handles them much better than the Straddle or Strangle.  For those who trade Iron Condors, you can throw that into the Strangle camp; I did not provide an example here as I wasn’t trading it at the time.

So, you can now see that the M3 provides a higher return (see previous blog) with a lower drawdown than the Straddle and Strangle.  Not bad.   Don’t be like Leonardo. Stay afloat and trade the M3!

Written and contributed by John Wilson