The Percent Profitable Fallacy
August 16, 2010
We first wrote about what we call the ‘percent profitable fallacy’ way back in 2003 as it involved trading systems and investors search for systems which have a high winning percentage (winning trades / total trades = winning percentage).
We wanted to re-visit the topic after a client started the popular Strategic ES trading system not long ago, and lasted for just three trades. The three trades were all losing trades, unfortunately; and the client quickly sent in instructions to stop trading the system. She had this to say: "The system is just guessing which way the market will go, that’s why it's winning percentage is no better than that of a coin flip."
What we said back in 2003, told our client the other day, and will repeat here: is that a high winning percentage has very little to do with the long term success of a trading system. And in fact most trading systems and managed futures investments are designed in such a way as to select winning trades at or below a 50/50 clip.
Many investors unfortunately equate a high winning percentage, be it the number of winning trades, winning days, or percent of months or years profitable – with the ability of an investment to make money; thinking that the more times a trader, manager, or system is right, the more money you make.
But the reality is much different. Consider that across nearly 23,000 trading days of daily return data for managed futures programs in our database, only 11,863 of those days (51.72%) were profitable. The rest were not, meaning you’re just as likely to open your statement tomorrow and see your account is worse than it was today as you are to see it is ahead.
And it isn’t just daily data. Your monthly statement from the managed futures program you are invested in is just as likely to show a loss as it is a gain – with only 57% of the 3095 months of data for the CTAs on our expanded list seeing gains.
Or consider the popular Compass trading system, which out of 1119 trades spanning back 10 years, has only seen profits on 535 of those (47.81%), yet has averaged 35.70% per year on a hypothetical model account using actual client fills. [please see hypothetical disclaimer below].
How can you lose more often than you win?
Many investors have a hard time comprehending that an investment program which loses on more than half of its trades can make money. The answer to how it is possible lies in the fact that you investments don’t have to lose the same amount they make – and in terms of most trading systems and managed futures programs, usually make more when they are right than they lose when they are wrong.
We can tell you when looking at the stats that the average CTA (across the programs in Attain’s internal database, not the entire universe of CTAs) is able to make money in just over half the month’s it is active, because it makes 5.58% when winning, and loses just -3.79% when losing. This spread allows for a smaller winning percentage. In contrast, option selling CTAs need a high winning percentage (they average a monthly winning percentage of 72.52%) because they lose more than they make when seeing losses (-6.33% in losing months, +4.78% in winning months).
Past Performance is Not Necessarily Indicative of Future Results
To help with this, take a closer look at how a program with a high winning percentage can get there. How does a model which wins on a large percentage of trades accomplish it? The system does so by risking a great deal more per trade. This keeps the system in more trades, allowing it to profit on more trades.
Imagine looking back over the past three trades on your system, and seeing that a $1,500 loss a week ago would have turned out to be a winner if the stop level had been just a half point further away. Adjusting the stop price that half point would have resulted in an extra trade in the win column versus the losing column, in turn causing the win percentage to tick up. The developer may then find another trade, where the stop only needed to be moved another half point, then another only half point, and so on — creating a curve fit nightmare.
The risk averse system, on the other hand, will look at how much needed to be risked on the handful trades which went on to make a lot of money, and go from there. These systems will risk a lot less per trade, getting the system out of more trades while waiting for that one "runaway" outlier trade.
It is mathematically difficult to develop a system which can have both a low risk per trade AND a high winning percentage, thus the reason you will rarely see a good trading system which has over a 60% win percentage. It's simply not worth the additional risk which must be taken on to increase the winning percentage.
In contrast, it is quite simple to create a trading system with a high winning percentage. The rules to a system which wins on 100% of its trades is below:
Rule 1: Buy Rule 2: Sell when profitable
This system, by definition, will have a 100% winning percentage, as it only exits when profitable. This system probably makes a very, very attractive rate of return also. You better bring your checkbook for this one, however, as it has unlimited risk. Imagine taking the signal in March of 2000 on Nasdaq futures. You would still be watching your screen for that sell signal, your account would have lost approx. $400,000 (although not closed out the trade yet), and your glorious win percentage would still be intact.
We actually coded this simple two rule system to see how it would perform, putting the system on Crude Oil futures. The results were as expected, with a 100% winning percentage, but a drawdown amount larger than the amount of money made (-$127K versus +$111K) [please see hypothetical disclaimer below].
Beware the ‘Reverse Lottery’:
So while it may appear logical that the more often an investment makes money, the more money it will make – it just isn’t the case because it ignores that crucial component: how much you make when right versus how much you make when wrong. Mathematically, we must consider the magnitude of winning/losing in addition to the frequency of winning/losing.
The sobering fact is that many investors have a need to be right, and are often times more interested in feeding that desire than actually making money in their investment. These are likely the same people with bumper stickers reading: "Success is in the journey - not the destination".
I would argue that in investing - the bottom line, or destination, is more important than the journey. Sure, we would ideally like that journey to be as smooth as possible; but the reality is that there will be bumps in the road. For those investors who have to be right a high percentage of the time, a good investment usually has more to do with psychology than profits.
This is why many investors are drawn to option selling. With option selling’s profile of risking a much larger amount than they stand to make – investors in option selling programs get to be right a high percentage of the time because the grand majority of options expire worthless. They get to reaffirm that their choice of investment was right more often (with a winning month), yet rarely realize that the trade off for that high winning percentage are oversized losses in the losing months.
Many of the more successful trading systems and managed futures programs operate on completely different logic, and take on more of an option buyer, or long volatility profile. This profile sees higher average winners than average losers, but may only win 40% or 50% of the time. An option buyer will make relatively small bets, knowing full well they will lose more often than they will win in exchange for the chance of inordinately large gains on the winners.
The lottery is a great (although extreme) example of an option buyers risk profile. You risk an insignificant amount ($1) on a ticket for the chance at 100s of millions, knowing your winning percentage is so far below 1% the odds of winning are 1 in a Billion or so. But while many people play the lottery, it is doubtful you will see an ETF launched any time soon with the same profile. After all, how many people would stick with an investment which lost $1 each and every day for years on end with seemingly no relief in sight, all for the remotest of chances of making that money back plus 1000 of times the investment?
Imagine playing the ‘reverse lottery’, where you would bring in a certificate for all of your assets (plus those of 10 generations after you) each day, and scratch off a piece of paper on which you have a near perfect chance of winning $1, but a 1 in 1 billion chance of losing everything you own. Would you play such a game? I wouldn't.
Yet most of our investing brains are wired in such a way as to seek out the investing equivalent of the ‘reverse lottery’. We hate to see losses so much that we usually accept a greater, unseen risk of loss in exchange for no up front, visible losses now. This manifests itself through investors searching out programs with a high winning percentage, or if only monthly data is visible – a high monthly winning percentage.
Ask yourself how many managed futures programs you have considered investing in which have had a losing year. Most of us scratch a program off the list if it has had even a single losing year. When doing this, we subconsciously move away from the risk we can see (a program with a losing year) for the unrealized risk we cannot see (a program with no losing years, yet).
People who either deliberately or subconsciously steer their money towards investments which win a high percentage of the time are often victims of a societal system which teaches us that success and being right are one in the same thing. One can see from the ‘reverse lottery example above how wrong that can be. Success with investing, it turns out, is more about limiting the damage when you are wrong than limiting the number of times you are wrong. The true lesson for our classrooms perhaps should be that it's ok to be wrong, just don't be wrong for long. In other words, cut those losses short.
In summary, each investor must look herself in the mirror and ask what is more important; being right or making money. If profit is the ultimate goal and not pumping the ego - then understanding that a smaller losing percentage is not only ok, but can even be a necessary step towards success will go a long way.
DISCLAIMER
IMPORTANT RISK DISCLOSURE
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Feature | Week In Review: Not so fast, equities/energies/wheat retreat...
Worrisome comments from the latest FOMC meeting and poor economic reports not only in the U.S., but from China as well, led to pressure in a majority of commodity and stock index futures last week.
Dark clouds hung over the marketplace after the Fed assessed the U.S. economy was turning back into a struggle after a brief growth spurt. Their post meeting statement indicated that all proceeds maturing in mortgage bonds would be rolled into longer-term government debt acting as a ceiling to keep borrowing costs low, which hopefully will aid a stagnating economy. Chinese news also was a bit discerning as reports indicated that growth might be heading back down toward the key 8% growth level which the marketplace didn’t take kindly too, especially after it was followed by a report indicating Chinese imports were less robust than previously anticipated. Some commodity prices overcame the Chinese news due to ongoing weather concerns in Eastern Europe, Russia and Pakistan which is expected to tighten world supplies more than the marketplace was recently comfortable with.
The end result for Stock Index futures was the worst weekly performance in 6 weeks as Russell 2000 futures -6.37% led the break followed by, Mid-Cap 400 futures -4.92%, NASDAQ futures -4.59%, S&P500 futures -3.88% and Dow futures -3.27%.
Price activity in the Energy sector reflected the weaker status of the U.S. economy and the slowing Chinese growth despite indications of rising crude imports for the U.S. during the past month. The demand uncertainty led to heavy depreciation with RBOB Gasoline futures -8.19% leading the way followed by Heating Oil futures -7.06%, Crude Oil futures -6.58% and Natural Gas futures -3.11%.
Metals price action reflected the turn in sentiment especially the industrials which have been pegged to Chinese demand for quite some time. Weekly activity had Copper shed -3.18% followed by Platinum -2.84%, Palladium -2.14% and Silver ended -1.81%. Gold +0.94% was the lone bright spot as flight to quality buying was a main feature.
The turn of events in economic forecasts led to a volatile trade in Currency futures as market participants fled to the safety of the U.S. Dollar +3.16%, especially after the FOMC indicated it would be purchasing long-term securities. This factor alone was enough to shake recent confidence that sovereign debt issues might not be in the rearview as previously thought which ended recent momentum of the U.S. Dollar carry trade. For the week Euro futures fell -4.00% followed by British Pound -2.19%, Swiss Franc -1.19% and Japanese Yen -0.75%. Rate futures featured a rally in U.S. 30-Year Treasury bond futures of 2.19% followed by U.S. 10-Year Note futures +0.81%.
Food and Livestock futures were again mixed although flooding in Pakistan, India and other countries in their region sparked a strong rally in the food and soft area as Sugar added +6.47% followed by Coffee +5.28% and Cotton +4.92%. Cocoa -5.06% and OJ -3.05% were unaffected by the weather issues. Volatility in the Grains settled some as recent weather worries subsided with forecasts of rain in the drought torn Russian grain belt. Corn +1.67% and Soybeans +1.03% did rally after the Monthly USDA reports indicated tighter supplies heading into the next crop season with Wheat -2.78% taking a breather after its torrid jump. Livestock trade was mixed as Lean Hogs added +1.05% and Live Cattle shed -0.52%.
Managed Futures
Multi-Market managers are finally starting to catch fire in 2010. July was a good month for most short-term multi-market traders who took advantage of late month volatility; while trend following programs have a had a very good start to August as trending conditions in treasuries, currencies, and grains have led to strong performance for longer term traders. The top performing manager thus far in August is Clarke Capital Global Magnum at +4.72% Clarke has done especially well trading in European bond futures as they are long both Bund and Bobl. Clarke Capital Worldwide +3.46% and Clarke Global Basic +3.11% are also off to strong starts.
Other multi-market programs who have seen success in August include Covenant Capital Aggressive +3.37%, Quantum Leap Capital +3.01%, Futures Truth MS4 +2.72%, 2100 Xenon Managed Futures 2X +2.53%, DMH +1.67%, Integrated Managed Futures Global Concentrated +1.58%, Hoffman Asset Management +1.42%, Auctos +1.02%, Accela Capital Management Global Diversified +0.58%, Mesirow Financial Commodities Absolute Return +0.26%, Applied Capital Systems +0.24%, GT Capital +0.03% and Sequential Capital Management +0.01%.
CTAs that are down for the month include Mesirow Low Volatility -0.04%, Dighton Capital Management Aggressive Futures Trading -0.33%, APA Strategic Diversification -0.69%, Futures Truth SAM 101 -1.08%, APA Modified -1.19%, Robinson Langley Capital -1.42%, and Dominion Capital Management -1.51%.
Short-term stock index traders were on the wrong side of last week’s late market selloff. Managers that were long include Paskewitz Asset Management 3X Contrarian -1.18%, Roe Capital Management Jefferson -6.53%, and Roe Capital Monticello -8.12%.
Option trading manager returns ended July mixed and have continued their mixed performance into August. The top performer thus far has been FCI CPP, which is ahead an estimated +3.75% and on new equity highs after finishing July -1.29%. The CPP program trades credit spreads on a wide range of diversified markets where it trades closer to the money than its sister OSS program - the proximity of CPP vs OSS allows it to collect more premium and potentially recover from drawdowns faster.
Other August Option trading estimates are as follows: ACE SIPC -2.29%, ACE DCP -11.46%, Cervino Diversified +0.11%, Cervino Diversified 2x +0.37%, Clarity Capital +1.34%, Crescent Bay PSI +0.56%, Crescent Bay BVP -0.78%, FCI OSS -0.98%, HB Capital +0.28%, Kingsview Management +0.99%, and, Liberty Funds Group -1.05%.
Specialty market managers have been in the “slow but steady” group of strategies for most of the year and are following suit so far in August. Leading the way is Emil Van Essen Low Minimum program which is ahead an estimated +1.24% while utilizing very little margin. This time of year has historically been of particular interest to the manager as Energy markets tend to turn a bit erratic ahead of hurricane season.
Outside of the spread trading, Fixed Income trading has been a hot mark so far this month and has allowed for the 2100 Xenon Global Fixed Income strategy to capitalize as it has pushed ahead +0.77%. Agriculture specialist have been mixed with NDX Abednego and Shadrach ahead +0.18% and 0.88% respectively and Oak Investment Group -1.43%.
Trading Systems
The second week of August was similar to the first week of August with few trades and a lot of choppy action. Once again the systems struggled to deal with the lack of direction in the equity markets.
AG Mechwarrior ES was a trading system that bucked the trend last week. It traded frequently and was able to handle the rangy action in the markets well. The highlight of the week for AG Mechwarrior was when it got short early in the day on Wednesday and benefited from the 35 point drop in the e-mini S&P 500 market for a profit of $1,237.50. Aside from that one trade, AG Mechwarrior entered the week long but reversed its positions at the right times last week and made a profit of $1,742.50. Other positive results were MoneyBeans S at $921.25 and MoneyMaker ES at $1,907.50.
On the flip side of things, many of the trading systems were “stuck” in their trades because the market wasn’t moving strongly in one direction or the other so the trading systems ended up waiting a long time for their profit or stop targets to be hit. Negative results for the week were Polaris ES at -$292.50, Strategic NQ at -$748.83, Strategic ES at -$802.50, BAM 90 Single Contract ES at -$1,817.50, Waugh CTO ERL at -$1,820.00, Strategic SP at -$4,400.00, and BAM 90 ES at -$9,780.00.
Day trading systems continued to be quiet for the month of August with only a few trading last week. Upperhand ES only traded once last week, but was able to make the most of that trade. Upperhand ES got short early morning on Wednesday and rode the selloff in the e-Mini S&P market for a profit of $357.50.
Compass SP traded twice last week, both long trades. Whenever Compass initiated a position in the market, the action seemed to disappear and as a result Compass would get stuck in the market. For the week Compass SP was down -$1,115.38. Other negative results included BalancePoint ES at -$61.61, Compass ES at -$222.50, Waugh ERL at -$350.00, Rayo Plus DAX at -$607.50, NPI Traders S at -$735.00, and Clipper ERL at -$807.08.
IMPORTANT RISK DISCLOSURE
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.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.