Grind it baby...........Capital Allocation

So, total return on capital = profitability * capital turn

Technicals
65% * 22.14% = 14.39%
Fundamentals
49% * 39.64% = 19.42%

Therefore we can see clearly the areas both need to look at.

The Fundamentals need to raise their capital turn ratio, as currently, 51% of the available cash is sitting idle. The Technicals, also have cash sitting idle, more than might be expected, and they need to raise their profitability if possible (although as a note, both far exceed industrial returns on capital)

The key ratio for both disciplines is the expectancy ratio.

So now we come to the nitty gritty................increasing the returns, putting dollars in the Bank.
Expectancy is the key.
If we had 100% expectancy, we could utilise 100% of our capital in the trade.
If we had 1% expectancy, we put it in the bank, or give it to someone else.

Obviously we are talking about risk management here. So lets list some available tools.
Diversification
Stoplosses
Value at Risk
Hedging
??????

Technicals have a combination of all three problems. They have incomplete capital turn, this needs to be up to 1.0 They have a low expectancy, and a less than optimal profitability. What they rely upon is individual skill, much more so than the fundamentals. Of course, daytraders could easily get to the 100% capital turn, and use 100% of capital per trade, but that can be hairy. I'll work through the calculations and just see how it works out on paper with the expectancy & profitability ratios. But a question for daytraders would be........how long does it take on average to achieve 1.0 on capital turn?

The second major problem, is that the stoploss is the primary tool of risk management. There are many problems associated with stops, however there is little other choice. Even the selling of covered premium could develop into a problem if you are stopped out of a trade.

Fundamentals, tend towards diversification. Diversification however has some serious drawbacks, and is directly responsible for the low Capital Turn ratio.That is the wider the diversification, the lower the risk, but the lower the return on total capital.

This is due to finding enough opportunities to allocate the available capital. The larger the account, the greater the problem. Buffett, in part, solved this problem by upping his expectancy to a very high level, and concentrated the portfolio, the exact opposite to diversification. If combined with a high profitability ratio. The answer may lie within a concentrated portfolio, but by utilising an alternate risk reduction tool, such as selling of premium, and or combining a directional put.

Some problems to work through. But it is essential to get it as efficient as possible, as losing money will impact your potential returns to such a huge degree. Losses were responsible for that 44% differential at the bank between the two methodologies.

cheers d998

Approaching risk management from the viewpoint of the expectancy and profitability.
Would it be reasonable to assume the following?

"the higher the profitability, the higher the expectancy"
Looking at the (limited) data, this is suggested, where profitability of 39.64 shows an 85% expectancy. Without a much larger sample, this will simply remain conjecture and hypothysis.

What about the inverse of that statement?

"the higher the expectancy, the higher the profitability"
From my own personal results, I have found this to be true. These are not posted live trades, so you will either have to take them at face value, or just dismiss them. Your choice.

Total # of Trades per Year....................................................17
Wins.........................................................................................17
Losses.....................................................................................0
Expectancy..............................................................................100%
% return on Capital...............................................................2.5% per trade compounded
Capital Turn............................................................................17.0

Using a bank of $100,000.00
The compounded return......................................................$152,161.83
% return on capital.................................................................52%

What this shows, from a different emphasis, is that, the success in cash terms resides in Capital Turn * Profitability and that Capital Turn is governed by Expectancy

Therefore, with a low expectancy, it will be difficult to attain a high capital turn, as, you must now employ risk management to the equation.

With the Fundies, this tends towards diversification, which while providing the risk management, will lower the returns, as Capital Turn drops and therefore profitability expectations must be maintained............viz. taking only potentially the best trades, which is where profit targets and or exits become the name of the game.

In brief, Risk management is about assessing your returns, based on calculations from your methodology, and then applying risk management to compensate for weaknesses in your profitability

It is not, about simply looking at, how much maximum loss will be inflicted on me if this trade goes wrong. That is only looking at half the equation, and out of context to boot.

cheers d998

Hello Ducs! Would it not be better to compensate for probabilty rather than profitability? The two are not the same! You need to get probable before you get profit/correct money management!

Rude

Hello Ducs! Would it not be better to compensate for probabilty rather than profitability? The two are not the same! You need to get probable before you get profit/correct money management!

Click to expand...

When you say, "compensate" for probability, what do you actually mean?
Do you mean,
1......Try to improve the "probability" (expectancy)
2......Apply risk management to the existing probability
3.....Or something different to what I understand?

It would seem that you are choosing option #1. In which case I agree. Now with Technical analysis, that seems to boil down to individual skill. In Fundamentals, while a modicom of skill is required, it is less than that required for technicals. The methodology, is more robust in of itself.

cheers d998

yet again you assume all 'technical traders' - what ever that means, enter trades in a brainless fashion, taking every set up that comes along.

winners dont do this. winners are not auto pilots. they have an edge that goes beyond a simplistic set of rules or 'system' or 'method'

personally, i am familiar with expectancy, but dont really use it as you describe - i dont think anyone who knows what they are doing would. personally i use it as a benchmark for my performance throughout the day. my e is based on previous REAL trades from the past x number of trades. if i am above e, then all is well. if i am below, then something is amiss. is it me or the way i am reacting to the market? e is dynamic - just like the markets. and so is my reaction to it.

expectancy IS NOT probability as you clearly try to explain above.

may i suggest ducatti that you put tharp down for a bit and earn some real experience in the market. it will be to everyones benefit, including yours i hope.

So going with the current statistics on the Technicals, we have a 57% expectancy, and a profitability ratio of 22.14% how could this as it stands be incorporated into a viable trading methodology.

Lets build one and see how it looks.
Lets also incorporate an intelligent use of leverage, to enhance the returns, and minimise risk at the same time

Expectancy .......................................................57%
Profitability .......................................................22.14%
Capital Turn .....................................................1.0
Time ..................................................................1 year
Leverage ..........................................................20

Risk Management
1......Diversification
2......Modified stoploss

Starting Capital $100,000.00......................................Diversification
# of positions ...............................................................100 directional "options" of 1yr expiry.
Wins................................................................................57
Losses...........................................................................43


Exit Criteria....................................................................@ 22% profit in stock price
Modified Stoploss........................................................Exit at 6mths for those trading below entry

Outcome.
Losses assume 100%................................................$43,000.00
Wins @ 22% .................................................................$12,540.00
Leveraged Return.........................................................$250,800.00
Net profit.........................................................................$207,800.00
% Return on Capital.....................................................108%

Now, the losses should not actually all hit 100% with a 6mth exit, but it will be variable. Either way, the losses should be less.

Now, however you currently choose your positions, support, resistance, breakouts, whatever, as long as you feel confident that your stats. at least equal, if not exceed the ones used, then, hey..............now all we need to do is test it with a 100 stock portfolio......volunteers?

Cheers d998

No takers from the techies...............what a surprise.
I'll run a reduced size portfolio of 10 stocks, and see what happens
cheers d998

Right I have spent a great deal of time in selecting these companies, approximately 5mins.

Stock ......Entry Price ......Option Price Entry ....................Strike .......................Expiry date
1.....RAI.....................$83..............................$3.80.............................$100.................Jan 2008
2.....VZ.......................$34.18.......................$0.60.............................$45....................."........"
3....ED......................$47.58........................$0.25.............................$70...................."........."
4....KSE....................$39.70........................$0.20.............................$45...................Feb 2006
5....DD.....................$44.20.........................$0.40..............................$70...................Jan 2008
6...KO......................$43.78..........................$0.30.............................$65...................."......"
7...DTE....................$42.72..........................$0.15.............................$55..................Jan 2006
8..MWV....................$28.11.........................$0.60.............................$35..................Jan 2008
9...ABS....................$20.70........................$0.15..............................$35..................Jan 2007
10..SO....................$34.96.........................$0.65..............................$45...................."......."

All positions are assumed to be equal $10K positions in the Options from a starting $100K
Lets see what happens
cheers d998

No takers? Can't have that

Just for fun then ...

2 x DIA Sep 2005 106.00 puts @$1.70 each = $342
1 x DIA Dec 2005 104.00 put @ 2.25 = $226
1 x DIA Mar 2006 90.00 put @0.80 = $81
1 x DIA Sep 2005 107.00 call @1.35 = $136

Multiplier x100. Total cost $785. Entry 20/7/05.

frugi

Interesting, you have gone for a concentrated approach, although, you seem have a short bias, there is one offsetting call in there.

For the purpose of testing the statistical 57%, I'll count all as 2 positions. 1 long, and 1 short. That they are unbalanced...........well we'll worry about that later, when some results start to materialise.

So now each position will have a hypothetical $8333.00. ($100K into 12 positions)
See if any one else jumps in.
Cheers d998

All positions are assumed to be equal $10K positions in the Options from a starting $100K
Lets see what happens

Click to expand...

So if I understand the criteria in position #1 you would have approx 26 option contracts?

frugi said:

No takers? Can't have that

Just for fun then ...

2 x DIA Sep 2005 106.00 puts @$1.70 each = $342
1 x DIA Dec 2005 104.00 put @ 2.25 = $226
1 x DIA Mar 2006 90.00 put @0.80 = $81
1 x DIA Sep 2005 107.00 call @1.35 = $136

Multiplier x100. Total cost $785. Entry 20/7/05.

Click to expand...

Frugi, does that startegy have a name?

BTW I am becoming a little bearish on the market myself but I doubt you will hit the target in the time you have allotted.

Exit Criteria....................................................................@ 22% profit in stock price

Click to expand...

roguetrader

Correct.
Obviously this is purely to test out the stats generated in the previous thread.
What I really want is 100 stock selections, long or short, with $1000 per stock selection.
No way was I going to find 100 stocks and update them each week, but a lazy approach of 10 was fine.

Frugi has added "two" one long, one short on the DJI.
And thats where we are at currently.
cheers d998

roguetrader

Well this is a purely mechanical system approach. It makes no effort at selectivity, or continuity, or any trigger at all.

Time is an interesting issue, that we haven't really touched on, but from this "mechanical" perspective, time value is what we are paying for, not any intrinsic value. Therefore, as a speculative operation, it has a certain logic that appeals to me

cheers d998

Rogue,

A name? No, not that I know of, sorry. My options expertise is minimal to be honest - 99% of my trades are intraday futures - so there's a good chance I will lose 100% of premium. However, I strongly feel the Dow will be <10400 before December and I will scale out accordingly if my view is correct. The call is there to sweeten the put losses on an upside BO, will sell around 10850-10900 if I get the chance and add another Dec put or two. Above 11k and I'll admit defeat.

Ducs,

Will it mess up the stats if I actively manage the position before expiry? Also I'm kinda 4 short 1 long but I see what you're doing to fit it in.

Your trade criteria is not really built for many technical traders I Know. Options with a one year expiry, 22% profit exit, or are those simply your criteria for your fundamental approach as Frugi has no doubt deduced?

frugi

Will it mess up the stats if I actively manage the position before expiry? Also I'm kinda 4 short 1 long but I see what you're doing to fit it in.

Click to expand...

Hell no, manage away.

roguetrader

Your trade criteria is not really built for many technical traders I Know. Options with a one year expiry, 22% profit exit, or are those simply your criteria for your fundamental approach as Frugi has no doubt deduced?

Click to expand...

No this is simply based on the profitability of the technicals from the stats generated. We needed an exit criteria, as least as a guide if nothing else..................22% is it baby.

cheers d998

No this is simply based on the profitability of the technicals from the stats generated. We needed an exit criteria, as least as a guide if nothing else..................22% is it baby.

Click to expand...

Yes but very few technical traders would be aiming for 22% gain on an underlying stock, Frugi will certainly be out of those positions before Diamonds moves 22% such a move would put the DOW at 8200 odd

8200? Now that would be lovely - returns with a k suffix

10400-500 and I'm out of those Sep puts as you say. They're short term. Mar will almost certainly expire worthless, quite cheaply. Dec will be the interesting one and provide the most difficult exit, I reckon. I'm not selling any of them at a loss, mind. No stop loss - eek!

roguetrader

Yes but very few technical traders would be aiming for 22% gain on an underlying stock, Frugi will certainly be out of those positions before Diamonds moves 22% such a move would put the DOW at 8200 odd

Click to expand...

Daytraders, and short-term swing traders would not be, agreed.
This risk management technique as that is what it is, looks to run a true .........no stoploss methodology via assuming a 100% loss in 43 out of the 100 positions, while the remaining 57 positions return an aggregate 22%

This aggregate 22% when leveraged by Options still returns a 108% return on total capital (100K)

Hence the requirement of long dated options. Thus, we shall discuss exits, as we get underway. But, we are looking for that aggregate 22%
Cheers d998