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Investing in Drawdowns: A Contrarian Approach

September 10, 2007


After watching Dighton Capital follow up its incredible run of about $40,000 in gains off of its April DD valley with another drawdown bounce back of nearly $10,000 in the past 15 days - and after seeing the Compass system hit new equity highs last month, representing a return of nearly $20,000 per contract since hitting its drawdown valley at the end of March - it seems as good a time as any to re-visit the logic of investing in CTA and systems at or close to new maximum drawdowns.

The basic logic of investing in a drawdown is similar to investing in beaten down stocks or buying something on sale. You get in for a lot less than you would have normally, and you stand to make a lot more than you normally would have should the program return to its winning ways. As the old saying goes: If you liked it at $50, you'll LOVE it at $25. Starting a CTA that is in the midst of a 30% drawdown not only means an investor saved losses of 30% by not getting involved with the system until those losses were realized, but also means that investor could make that same 30% in profits when and if the system returns to its original level.

The Dighton Capital program, in particular, seems to have a real knack for bouncing off of the 30% drawdown level - having seen nice returns after hitting that level on four separate occasions in the past one and a half years. Attain has notified several clients about this phenomenon, and some have set up Dighton accounts to catch the next "bounce" off of the 30% drawdown level. Their accounts are open, Dighton's management documents signed, and money ready to trade sitting in T-Bills earning interest - while all they have to do is say "Go!" the second we notify them Dighton has hit the 30% down level intramonth.

The returns for this approach on Dighton since 2006 are as follows:

Past Performance is Not Necessarily Indicative of Future Results

While the verdict may still be out on the long term performance of the most recent case in April 2007, the other cases show very strong performance in the 3, 6, and 12 month periods after the program hits the 30% DD level.

"Reverting to the Mean"

What is likely going on here is a statistical phenomenon called reverting to the mean. This is really just a fancy way of saying what goes up must come down, and the less often heard: "what goes down must come back up", and a good way of thinking about it is that performance usually comes back to its averages over time.

Unlike stocks or funds, a trading system investment won't benefit from increased money flow, and on the flip side won't suffer from decreased interest or money flow. A stock can gain momentum one way or the other by a lot of people simultaneously buying it and running the price higher, or conversely a lot of people selling it and driving the price lower.

A managed futures program operates independently of how much money is coming into or out of the investment, crunching its technical formulas on the current market environment, whether that market be soybeans or S&Ps. The problem(or benefit) inherent in any mechanical system or trading strategy is that it is designed to do well in a particular type of environment, meaning it is not likely to do well outside of that environment.

The same thing that makes investing in "hot" systems dangerous makes investing in beaten down systems advantageous, and that is the fact that environments change. Governments, economic cycles, weather, science, and people change every day, causing the specific environment a particular CTA (or its current positions) likes to either be in or out of phase. If a particular strategy is currently out of phase - a change in environment could be just what the doctor ordered for a program in a drawdown. The tough part, as always, is knowing just when that change occurred.

The benefit of investing in a program at or near its historical Max DD is that the program has most likely just lived through one of the least desirable market environments it could imagine. Many times, there is a perfect storm of sorts in which several conditions fail to line up for a program. Will things continue to go against that system in the same way? Will market conditions NOT change? Don't bet on it. To the contrary, bet on them changing.

Now, there's an old saying that you will run out of money before the market returns to reason, which could just as easily be stated you'll run out of money before the market returns to its averages or an environment a CTA program is suited for; and that's exactly why investor's need to limit the downside of investing in drawdowns as best as they can.

A limited downside:

Part of the attractiveness of buying a stock after its been beaten down or investing in a futures program at or near its maximum drawdown is not just the potentially unlimited upside, but is also about the limited downside (or at least less of a downside than before). This is especially important for those investors who are saying, "But what if it never makes any more money? What if the program just keeps going down, adding to its drawdown?"

I'm glad you asked. This limited downside is especially pertinent in a trading system investment, because a trading system's backtested hypothetical results give investors the ability to preset a "line in the sand". For a CTA investment, investors need to look "behind" the numbers and find out what the maximum intramonth DD has been and get the tested or expected worst case maximum DD. The "line in the sand" is nothing more than a worst case scenario level at which point an investor should consider the system broken and stop trading it, thereby protecting the account from going further and further down.

Attain uses several measures for calculating "lines in the sand" for each system - but the math usually works out in such a way that the line in the sand is usually 1.5 times the tested, prerelease maximum drawdown of a system and 1.5 times the maximum intramonth DD for a CTA. If you're investing in a CTA with a limited track record, find out what their worst case maximum drawdown was in their testing, and base your line in the sand off of that number.

So, for an investor thinking of investing in a DD with the Dighton program while that system was in a 30% intramonth DD in April of this year - they could calculate their downside by looking back at the program's past worst maximum DD and multiplying that by 1.5. The past maximum intramonth DD had been 30% (twice), meaning the line in the sand could be 45%, and so the risk on investing in this DD was simply the difference between the current DD level and the line in the sand level, or 15%.

The potential gain over the following 12 months was the sum of the 30% DD and the system's average annual return of nearly 75%, while the risk was just 15%. That's the potential for 105% gains and a risk of just 15%, or nearly seven times as much profit potential than risk. You can look around for a long time and not find much better odds than that with an investment.

August DDs = Opportunity

With several successful CTAs seeing new maximum DDs in August, such as Zephyr, ACE, Chicago Capital, and Nu Wave - many contrarian style investors are wisely asking if right now might not be a great time to invest in some of these names. Our answer is a resounding yes, this is a great time to get invested in some very highly rated CTAs.

But we also wanted to put that feeling to the test, statistically, and we set out to test whether investing in DDs is a good idea for CTAs in general, as it appears to be with Dighton Capital. The results were encouraging, with the averages showing good performance in the quarter, half year, and full year after our drawdown trigger was hit.

Our process for testing this investing in a drawdown strategy was to use the Credit Suisse/Tremont CTA Index data to represent the "average CTA". While the Credit Suisse/Tremont CTA Index has an average annual return of just 6.92% and a max DD of -18.72%, and is not entirely representative of the highly ranked CTAs Attain seeks out and recommends, the fact that it performs worse than the CTAs we track, on average, is a good stress test for our theory.

The problem with investing in DDs, of course, is you don't know when the DD is over, until after the fact. So if you start into a DD, there is no way to know if the month just completed is the low point of the DD, or whether the DD will keep heading lower in the coming months. For that reason, any strategy to invest in a DD has to start with identifying what level of DD is large enough for you to invest in.

The table below shows the results of investing in the drawdowns of the CTA Index at various DD trigger levels. We measured the 3, 6, and 12 month performance after each DD level was triggered in succession, and then averaged each time period to see the average 3, 6, and 12 month performance for each trigger level. The average 3, 6, and 12 month performance of the Index itself is listed on the far right for comparison.

The trigger levels were calculated in two ways. First, we took the first max DD of the CTA Index (-9.57%), and used fractions of that level as the trigger for investing in future drawdowns, looking at investing every time the next DD after a new equity high was 75% of the 9.57% DD( -7.18%), the same as that DD (-9.57%) , 125% of the DD (-11.96%), and 150% of the Max DD (-14.36%). The second trigger level looked at the current DD versus the cumulative average DD, and we tested the performance when the current DD was 125%, 150%, 175%, and 200% of the average.

The results show that investing in drawdowns is indeed viable, with 63% of the periods tested showing better performance than the average for the same period. For example, using 150% of the initial max DD as the trigger, the 3 month performance was 7.57%, versus the index's average of just 1.73%. The testing also shows that waiting for a bigger DD helps a lot, with the two higher trigger levels for both methods showing each period above the averages.


With several prominent CTAs in drawdowns and the stats supporting this contrarian approach, we believe its time investors put money to work during these drawdown phases. Programs like Zephyr, Chicago Capital, and the others will not be in drawdowns indefinitely in our opinion. We can work with individual investors to run tests on specific CTAs you're interested in, and find a trigger that fits into your risk tolerance levels. Please email us at for more information.


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Feature | Week In Review: | Chart of the Week


For the first time in four years, it was reported that the US employment market showed negative growth. The August unemployment report (or unenjoyment as the locals in the Pit like to call it) showed that the US economy lost -4000 jobs in August. Plus, as a kicker, the government had a downward revision for its previous positive jobs reports from June and July. As expected stock futures tumbled with SP 500 futures losing -1.14% last week, Nasdaq futures were down -1.22%, and Dow futures were down -1.48%. In the small caps Russell 2000 futures fell -1.82% and SP Midcap 400 futures lost -0.95%.

Bond futures rallied on the report and throughout the week as traders expect the Fed to cut interest rates by at least 25 basis points next week and perhaps by another 25 basis points in October. US Bond futures closed the week up +1.57% and 10 year note futures were up +1.38%. In currency trading the Euro gained again against the Dollar with Eurocurrency futures climbing +0.92% while Dollar Index futures fell -1.03%. Japanese Yen futures were up big as well (+2.20%) due to speculation that hedge funds where unwinding the popular Yen carry-trade once again.

Commodity traders also saw several big moves last week across the energy, grain, and metals markets. Energies climbed higher in anticipation of OPEC deciding not to increase output. Crude futures were up +3.59% last week and Heating Oil futures climbed +4.17%. The RBOB gas market remained quiet however and finished the week nearly unchanged while Natural Gas futures climbed only +0.60%. In metals trading both Gold and Silver moved higher as investors continue to seek a safe haven for their money. Gold futures were up +4.08% last week and Silver futures climbed +4.33% higher. Platinum +1.84% and Palladium +0.98% also moved higher while High Grade Copper futures fell -4.28%. Finally grains continue to be very volatile as well. Wheat futures rocketed higher +8.77% after Russia announced they would halt exports. Soybeans +2.58% and Corn +2.21% also traded higher.

***Commodity Trading Advisors (CTAs)***

In general, last week investors saw the most action in the index option selling portion of their portfolios. With only 3 weeks remaining on the September option cycle mangers such as Zephyr, BC Capital, Zenith, and others all actively engaged the markets looking to capitalize on the remaining Theta (Time Value of options) and increased Vega (Implied Volatility) of the options markets.

Elsewhere, last week was a positive week for the agriculture spread traders NDX and Chicago Capital as grain and meat markets both began to close the gap on end of year spreads. Active accounts with both mangers actually experienced an increase in position sizing based on the expected strong recovery of these markets – stay tuned for an update on these positions.

Beyond the above, if you are considering investing with a manger not on our recommended list we encourage you to e-mail us at for a complete review by our research team before putting your hard earned money to work. We have a rigorous due diligence process that each and every recommended manger must go through and are happy to look into any and all mangers for you free of charge.

***Day & Swing Trading***

A sharp sell-off in equities and the corresponding rally in bond markets paved the way for plenty of trading opportunities in both swing and day trading systems. Systems trading foreign markets fared the best with the top three performers trading the Eurobund and Dax markets.

Starting with the top performer, Signum EBL made +$3,829.70 after rolling its current open long position to December and tacking on additional open trade equity. The system is now holding half of its initial long position after reaching a profit target over a month ago. Signum TY was next in line at +$1,500 after bond markets surged following the unemployment report on Friday morning. Tzar eRL held its short position and tacked on +$1,450 in open trade profits. Mesa Notes exited its long position late in the week for profit of +$1,434.37 for the week. Tzar ES also held its short position for profits of +$850 while Tzar NQ was forced out of its short position for a loss of -$514 on the week.

The Ultramini systems had a tough time last week with losses of -$700 in the YM, -$705 in the ES and -$1,070 in the eMD. Seasonal ST ES and eRL were holding long and gave back all of the prior open trade profits for losses of -$942.50 and -$1,530 respectively for the week. Finally, Mosaic eRL had four trades for a loss of -$2,505.

Moving on the day trading systems, Rayo Plus Dax and BetaCon 4/1 Dax were neck and neck with profits of +$3,131.03 and +3,047.93. BetaCon 4/1 ESX traded four times for profits of +$589.20. Compass SP traded three times for a small profit of +$50. Waugh eRL had two trades for a loss of -$690.

***Long Term***

The U.S. Dollar headed to multi year lows last week as stats showing a slowing U.S. economy prompted foreign investors to dump dollars. The unwinding of the Yen carry trade was again evident last week as the Japanese Yen moved up near its recent eight-month high with nervous investors liquidating due to global stock market weakness. The Euro zone currencies firmed the most on U.S. dollar weakness on ideas that the ECB would follow through on a rate increase by the end of the year due to strong economic activity. Economic releases in the U.S. this week continue to be on the light side, but there will be key reports on the health of the manufacturing sector via various reports that could prompt more momentum from what was garnered last week. Long term trend followers have moved into a mostly neutral stance as Aberration exited the recent short in DXU losing -$1270.00.

The firm tone in rate futures continued during the past week as several contracts in the sector eclipsed levels not seen since October 2006. The new surge was sparked by another round of global stock market jitters that prompted ideas that the U.S. Fed will move to inject more liquidity into the system via a rate cut at their next FOMC meeting. Although the past Fed moves seemed to take the edge off of the recent equity decline ideas remain among market pundits that a cut in the Fed funds rate next week is still in the cards due to weaker U.S. economic readings. The upcoming week’s economic releases are light, although key manufacturing readings should keep the markets focused on the pulse of further economic erosion. Long term trend followers have had a neutral bias recently, but Aberration jumped into the mixed this past week and enter a long TYZ position with a current gain of +$1265.00 (Open Trade).

Most sectors of soft commodities posted gains during the past week on ideas that global demand will remain strong not to mention that some sectors are experiencing production problems. The wheat market continues to be strongest performer as world wide crop problems and tightening supplies sparked prices to record levels. The livestock sector was weaker on lower cash and product markets, although news that China was ready to buy extra product to add to their tight freezer stocks kept Lean Hog losses minimal. Look for underlying support in the grains and oilseeds to continue on worries of world crop problems for wheat and ideas current row crops will not meet big expectations. Aberration is currently long KWZ making $5887.00(open trade) and short CZ making +$125.00 (open trade).

Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.

Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.

Please read carefully the CFTC required disclaimer regarding hypothetical results below.