November 15, 2015

Risk

Weather Helm = Risk Management.

Win by not losing.

Every position, and every prospective trade, begins with a careful analysis of worst case scenarios. By focusing on what may go wrong, and seeking to limit downside risk, we preserve capital for potential appreciation. Anyone who has suffered through a market meltdown while in a typical stock-heavy mutual fund portfolio has come to understand the debilitating effects of negative compounding. Put simply, if you suffer a 50% loss in a given period, you must gain 100% in the next just to break even. In 2008, the S&P 500 suffered a 37% loss. Thus a gain of 58.7% was required to get back to even.

CatchUPGap

We refer to this as the “Catch-up Gap.” For many investors the psychological impact of these losses is devastating, panic ensues and portfolios are liquidated under the worst possible conditions. Our first goal at Weatherhelm is to avoid these situations by exercising a strict sell discipline.

Fixed-fractional Risk Management

Our sell discipline is dictated by our fixed-fractional money management strategy. This means we are only willing to risk a fixed percentage of the total capital (“f“) in an account on each position. For example if f is 1% and an account has a total value of $1,000,000, we would be willing to risk $10,000 on any one position. The absolute loss we are willing to tolerate in turn controls our position size and stop-loss level. Investors tend to focus exclusively on entry price, when in fact position size is as important and also under one’s control at the time a position is initiated. By paying careful attention to downside risk, we seek to avoid crippling draw-downs.

Anti-martingale Position Sizing

Our anti-martingale management strategy can be best explained by what it is not: typically we do not add to losing positions. This goes against the conventional wisdom that it is useful to “average down.”

roulette

Why do we disagree?  Because there betting limits at roulette tables.

In theory, given unlimited capital and unlimited time, a player could never lose by always betting on Black. Consider the following example:

  • Bet $100 on Black.  Lose.  Total Profit: -$100;
  • Bet$200 on Black.  Lose. Total Profit: -$300;
  • Bet $400 on Black.  Lose.  Total Profit: -$700;
  • Bet $800 on Black. Lose.  Total Profit: -$1,500,
  • Bet $1,600 on Black.  Win.  Total Profit: $100.

In this hypothetical, by doubling the bet after each loss, the Martingale Gambler is sure to win in the end.  In practice, this strategy is impossible because casinos have table limits.  In markets, we have margin clerks.  What the Martingale Gambler has done here is risk $3,100 to win $100. This is a Taleb payoff, not the kind of odds we’ll take at Weatherhelm.

Instead we prefer to add to winning positions.  To grow our positions when they are working for us, with the goal of building a large long-term gain. This is how fortunes are preserved, and we feel how fortunes can be made.

Option Overlays

Those who disparage derivatives fail to understand how they can be used to reduce risk. Standardized options are indeed derivatives, but there is nothing inherently good or bad about them. They are merely a vehicle: it depends on how they are used. Used prudently, options can reduce the overall risk of a portfolio. At Weatherhelm, we employ covered call and cash covered put option strategies where prudent to increase income and lower risk. We never sell uncovered options.

WhSprd

The “Weatherhelm Spread” depicted above is an example of a synthetic long position strategy we like to employ when conditions permit. This combination provides a similar unlimited upside as a long position in the underlying stock, with the added benefit of a pre-defined limited loss. This strategy exhibits “Weather Helm” by automatically increasing exposure as the underlying appreciates in price and reducing risk in the event that prices fall.