Contents
- Step 1
- Steps 2 and 3
- Step 4
- Another Scenario
- CPPI Rebalancing
- Caveats
- Drawbacks Of This Strategy
- Who Might Use This Strategy?
Guarantee is a strong word.
Let’s use “almost guarantee” instead.
We hardly ever use the word “guarantee” in investing.
We know that market can do anything at any time.
We know that there is no strategy that works all the time.
The only time there is any guarantee is to not trade or invest.
And that is exactly how this strategy works.
This strategy is based on the Constant Proportion Portfolio Investment (CPPI) strategy, but not exactly.
It is a more simplified version.
- Set 80% or more of the portfolio in cash
- Invest using only 20% or less of the portfolio
- Make sure all investments are all defined-risk strategies where the total of all max loss is within limits of the 20% portfolio allocation
- Re-balance by moving any gains to the cash allocation portion of the portfolio
Step 1
Divide your portfolio into two portions.
Some investors may actually use two different accounts or brokers.
In any case, think of them as two sub-accounts: the cash sub-account and the investment sub-account.
The cash sub-account is for holding cash or interest bearing instruments that have no risk (like a checking or savings account).
The investment sub-account is the one that is used for trading.
Even if you lost your entire investment, your cash sub-account still contains the 80% that you have not lost.
Steps 2 and 3
This only works if all investments are defined-risk strategies where the total of all maximum loss is within limits of the investment sub-account.
This means no shorting of stock, no naked puts or calls, no front-ratio spreads, no short strangles / straddles, or other undefined-risk strategies.
This means investor needs to know how to calculate the max loss on iron condors, credit / debit spreads, butterflies, back-ratio spreads, etc.
This means that you are tracking (or software is helping you track) the total possible max loss of all trades.
Step 4
Suppose an investor’s portfolio is $100,000.
And $20,000 is used for investing.
That $20,000 grew to $23,000.
Does that mean that the investor can now trade with $23,000?
No.
Let’s see why.
Investor made $3000 in profits.
Now the total portfolio size is $103,000.
Calculating 20% of that is $20,600.
The investor can only trade with $20,600.
The investor needs to rebalance by moving $2400 from the investment sub-account into the cash sub-account for safe keeping.
The cppi rebalancing only goes one-way.
Money goes only from the investment sub-account to the cash sub-account.
Under no circumstance does money move from the cash sub-account to the investment sub-account.
Otherwise, the guarantee is voided.
This is because a “20% drawdown” means never losing more than 20% from the highest point ever.
It doesn’t mean never losing more than 20% from your initial portfolio size.
Another Scenario
Let’s look at another scenario to see if we understand the above point.
Suppose an investor’s portfolio is $100,000.
And $20,000 is used for investing.
Unfortunately, half of the investment is lost.
Only $10,000 is left in the investing sub-account.
The total portfolio size is now $90,000.
Since 20% of $90,000 is $18,000.
Does that mean the investor can trade with $18,000?
No.
Because that would involve moving money from the cash account to the investment account, which violates the above one-directionality rebalancing rule.
The investor can only trade with the remaining funds in the investment account which is $10,000.
Just because you cannot lose more than 20% of your portfolio is no reason to be reckless and trade however you want.
Because if you lose that 20% investment sub-account, that’s it.
Game over.
You cannot use the cash sub-account or move money from it.
The only option is to save up more money to deposit into your investment sub-account.
CPPI Rebalancing
The rebalancing can occur on a regular time interval basis (such as once a month).
Or it can be done whenever the investment sub-account has reached a certain percentage of gains (say 10% etc).
Caveats
Even if all the rules are followed, there are rare instances where it is possible that drawdown can become more than 20%.
This can occur when an investor is trading at the limits of the investment account and any of the following happens:
- Re-balance timing is bad such that investor trades with funds that should have been siphoned out to the cash account.
- The actual max loss on an option trade exceeded the theoretical max loss. This can happen if investor closes out the trade prior to expiration at a point when volatility and slippage is unfavorable.
- Assignment and gap risks. For example, an investor has a bull put spread where the stock priced landed in between the short strike and long strike at expiration. The investor is assigned the stock and the protective long leg has expired (no longer exists). The next day, the stock gaps down to a price that is below what the long strike price had been. The investor has paper losses that exceeded the max loss of the bull put spread.
A bull put spread is a defined risk strategy with a max loss.
However, this only applies prior to or at expiration.
What happens after assignment post-expiration is not bound by that max loss.
For these reasons, have some buffer and/or not trade at the limits of the investment account.
Drawbacks Of This Strategy
Because this is a conservative strategy with a large portion of capital sitting idle, this strategy can underperform in bull markets.
Keep in mind that 20% was just an example.
An investor is free to choose a different percentage division between the two sub-accounts.
The account can “lock up” after a market crash and not be able to participate in the subsequent recovery.
It is possible that the investment account is completed wiped out in a market crash leaving the entire portfolio in the cash account.
There is no more investment money available to participate in the recovery unless new money is deposited to the investment account.
Who Might Use This Strategy?
1. A hedge fund manager that advertises that the fund will not have a drawdown of greater than 20%.
2. A trader at a proprietary trading firm whose manager will fire any trader that loses more than 20% of their allocated trading fund.
3. A retail trader whose spouse will disallow trading if more than 20% of the retirement savings is lost.
4. Any investor who would like manage risk and to limit drawdown. That should be all investors. However, whether to do this using this strategy or to manage risk in other ways is for them to decide.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
