Allocation in Abnormal Markets

By Jared Woodard | November 20, 2008 | 1:35 PM | 0 Comments

As we said to the members this morning, when all your historical studies are broken or unhelpful and the market is behaving inexplicably, there’s really only one sensible way to think about capital allocation:

Look at the positions in your account this morning.  If each one of those trades closed at its absolute worst possible price - its “maximum loss point” - would you lose a minute of sleep?  If the answer is yes, your trades are too large, and you should resize those positions until you are comfortable with any possible outcome.

No hyperbole there: in this market climate even trades that would normally count as conservative are just as likely as not to end up losing.  Stock/futures traders can respond to this volatility by using looser stops to avoid whiplash.  Option buyers can take profits more quickly than normal - if a position is down, just wait 10 minutes, and then close it at a profit.  Option sellers can go further out of the money than they ever thought possible, and split capital into tinier chunks so that they can sell more premium when volatility get inexorably higher in subsequent sessions.  And everybody should be trading in much, much smaller position sizes.

The difference between the market today and the market a year ago isn’t that one is bullish and the other bearish.  The difference is between normalcy and abnormality.  A year ago, people were asking us to compare the profit factors of various strategies.  Today, everyone (rightly) seems to care more about survival.

Allocating capital on the assumption that each trade will be a complete loser obviously isn’t as sexy a model as, say, Value at Risk.  But then again, only one of those models can guarantee that you’ll be around tomorrow.