Tuesday, 24 February 2015

Cookies and leverage

14:01 Posted by The Thalesians (@thalesians) No comments

There is a place on West 74th Street in New York, called Levain Bakery. From the outside it's fairly anonymous. On a Sunday morning, there's often a queue outside. Descend the steps into the bakery, and you find many bakers frantically producing trays and trays of cookies. For several of your US dollars, you can buy (and most importantly enjoy) one of these cookies . Admittedly, they aren't very cheap. However, they do taste something somewhere near a place I would call perfection. On the downside, they are very filling, and I had trouble eating lunch after having one of these mini masterpieces.

Just imagine, if however, you could eat as many cookies as you wanted, without ever putting on weight or even feeling full? Of course, such a notion is highly unrealistic (and I doubt anyone reading this would dispute this).

However, for whatever reason, in markets, it is somewhat easier to fall foul to what I shall term the "cookie fallacy". This is simply, the belief that somehow, we can break the link between risk and return, or we can focus on returns, rather than risk. Hence, we focus on the upside rather than the potential downside of a trade. The difficulty is of course, the key to generating returns is not so much about positive returns, but also the lack of losing trades. If we deploy more and more leverage, taking greater risk, then we increase the potential downside at the same time. This is not a diatribe against taking risk (or indeed eating cookies). It is merely that the case of how we take risk (or have cookies) should be reflective of what losses we are able to stomach.

I have been in the market for a decade. Much has changed in that time. I have run systematic trading strategies both within banks and also over the past year and half with my own capital, alongside consulting on systematic trading strategies. Perhaps unsurprisingly, this has very much focused my mind on the whole idea of risk taking!

Despite the fact that nearly all my trading has been on systematic trading strategies, I still have to use my own discretion to size my trading book. My main criterion is never how much money I could make. Instead, it's how much money could I lose. Indeed, this is the same approach I have used whether one of my strategies has been traded using a bank's capital or my own (although in a bank, of course, risk limits are imposed on you too).

In terms of trading my own cash, I have had a respectable Sharpe ratio, at over 2, since I started over a year and half ago. If I had leveraged up significantly of course on a theoretical basis, I would have made more money! However, looking back at my P&L stream, I have at times (inevitably) had some drawdowns. These have been painful but also tolerable. Had I leveraged a lot more, I suspect these periods of poor performance would have been too much to take. As a result, it might have been the case that I would have simply cut all my risk. Is the risk I've taken "optimal"? Probably not, but I prefer to have taken a bit less risk than too much.

Whilst there are similarities when it comes to taking risk on your own cash and external capital, there are important differences, which we discuss below.

First, capacity becomes more crucial when handling external capital. If you deploy too much capital on a strategy, performance might begin to downgrade. Nearly all the strategies I trade with my own cash are intraday strategies. The capacity of such strategies is relatively low compared to daily or monthly trading strategies. When trading your own capital, you probably won't come up against capacity issues. However, when trading large amounts of capital, if you take on external capital, you might well come up against this, which would curtail your leverage (unless you came up with more strategies to trade).

Second, somewhat stating the obvious, the limit of the drawdowns you can tolerate on your own personal capital is likely to be somewhat lower. Also the pool of strategies you might be able to run might be lower with similar levels of leverage. Say for example you might like a certain strategy which trades relatively volatile assets. When it comes to running in your own personal portfolio, the weighting you give it might be lower than with a larger external portfolio. Obviously, if you would never be prepared to trade a strategy with any sort of leverage with your own money (but you would with others money), there's the question of whether you should really be investing in that portfolio with anyone's cash!

Leverage (like cookies) isn't intrinsically bad, it's just that it need to be used with care. If we just eye a healthy return, without an appreciation of the risks we take, we might end up perversely curtailing our long term upside. Indeed, this is one of the themes of my new book, Trading Thalesians!

Like my writing? Have a look at my book Trading Thalesians - What the ancient world can teach us about trading today is on Palgrave Macmillan. You can order the book on Amazon. Drop me a message if you're interesting in me writing something for you or creating a systematic trading strategy for you!


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