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5 Rules for living through a Drawdown
October 29, 2007
With the popular FCI (Financial Commodity Investments) CTA program seeing its biggest drawdown since the spring of 2005 due to the recent run up in energy prices - and one of the top trading systems at Attain, AG Mechwarrior ES also suffering through a drawdown period in October, its time we revisit drawdowns and how to best handle them.
What is a drawdown? A drawdown is quite simply the amount of money between a peak in your equity and the subsequent low level in your account. An investor with $100,000 in her account as of the end of January, $75,000 in her account as of the end of March, and back over $100,000 at the end of June has experienced a 25.00% drawdown. ($75K - $100K = -$25K/$100K = -25%). The account made back what it lost, but at one point it was down 25%, and that is the number we want to know, as it represents the maximum amount of losses which had to be experienced.
Because a drawdown is the difference between a portfolio's highest valuation (in a given period) and its lowest subsequent valuation, an investor is by definition always at either a new equity high or in a drawdown. Most people think of drawdowns as an extremely rare event or at most a once a year or quarter event - but the fact of the matter is that investors will spend just as much time in drawdown (even if its a nominal one of just $500 to $1000) than they will at equity highs.
So if you're going to spend about 1/2 of your time in drawdown, you need to learn how to measure and handle it, and we've come up with a few rules of thumb sophisticated investors follow:
1. Expect the Drawdown, don't be surprised by Drawdown: We all look at the drawdown numbers in performance reports and seemingly give them their due, but then we see them in OUR account; and sometimes act like we never expected to see them. "Trees don't grow to the sky" is a familiar expression in the investment world, and simply means we shouldn't expect an investment to make money each and every day of each and every month. Things simply don't go UP forever. They pause, go through down cycles, bear markets, etc. This is especially true of mechanical trading programs which prefer certain market environments to other ones.
So don't be surprised by drawdown, especially if it is well within the historical parameters of the program. For example, the FCI program has had a maximum DD of -16.26% in the past, from April - July of 2005. More recently, FCI has been on the wrong side of statistically improbable moves in the Wheat market in September (leading to -5% losses) and now the Crude Oil market in October (leading to losses around 7%). Doing some quick math, that's a DD of only about 12%, which is just 74% of its past historical DD.
In short, the current FCI Drawdown is not a signal that the strategy has broken, or anything close to that. We can all be upset, and not like the losses, but they should not take us completely off guard, as if we never expected the program to have a string of losing months. We've seen losing strings in the past, and it is part of the natural ups and downs of the program. The over exaggerated market spikes we've seen in Wheat and Crude Oil are the exact things which cause losses for the FCI program, and as extreme as they have been, the program is still well within its historical max DD number (-16.2%).
2. Be properly capitalized to handle a similar drawdown. There is nothing worse than quitting a program during a drawdown because you had to meet a margin call, and then seeing the program recover from the drawdown and go on to make new equity highs. The investors who were properly capitalized go on to see the new profits, while those who weren't got forced out at the lows - locking in the losses.
By studying a program's past performance and/or back tested results carefully and basing your decision to start trading a CTA or system off the draw down and profits in those reports, you sort of hope history will repeat itself. If it does, you stand to make a good profit. But when history does repeat itself, don't be shocked when the draw down happens again. The drawdown is just as much a part of the history as the profits.
Being properly capitalized is especially important for those investors who notionalize their accounts. Investors who notionalize must take into account the amount of margin the program is designed to use, plus add in the possible drawdown. That sum is the minimum capital you should have to trade the program. If you just put in enough money to handle the Drawdown, when that drawdown happens, you will have no money left over to cover the margin, and you won't be able to put on any new trades, just when the program is likely to bounce back out of its drawdown.
Take the Dighton Capital program as an example. Dighton has averaged gains of nearly $70K on a $100K account over the years, but has also seen Drawdowns close to $40K with some frequency. Dighton's minimum is $100K, meaning you can notionally trade Dighton with $50,000 in the account, and $50,000 in notional (imaginary) money.
If you open your Dighton account with just $50K in cash, and it heads straight into a $40K Drawdown, you would have just $10K left in the account. That $10K needs to be enough to meet the margin requirements, or else you'll be forced out of the program just as it is likely to turn around. The easiest way to make sure you are properly capitalized is to simply trade the recommended minimum amount given by the CTA or trading system. They have set those minimums to take into account margin AND drawdowns.
3. Always assume the worst drawdown the system will ever have is in the future. Add drawdowns to the old line about death and taxes - you can't escape them. Just after we've told you to make sure you know what the past drawdowns are, and expect those to happen, we're going to tweak the rules a bit. You should also expect and assume that a new max DD will always happen in the future (after you've invested). This new max DD doesn't have to be 5 times the old one, but you should always add a little mental cushion to the historical max DD.
For example, starting the FCI program, and seeing a past Max DD of 16.2%, I would personally assume that I'm going to see one around 20% in the future. If I expect a new max DD to happen in the future, I'm not a nervous wreck who can't think straight when and if a program makes a new maximum drawdown. I can take it in stride, step back, and asses the program rationally.
Many investors simply don't prepare themselves mentally for the drawdown, and this leads to emotionally driven decisions at the worst possible time in the worst possible place. These emotional decisions lead to that trait all bad investors share - getting in at the high, and getting out at the lows. An investment in a professionally managed CTA or mechanical trading systems is no place for emotional decisions. The very strength of CTAs and trading systems is their ability to eliminate the losses caused by emotional decisions, so we don't want to offset that advantage by acting emotionally when in DD.
4. Have intestinal fortitude. There's no such thing as risk free returns, the larger the returns, the larger the risk. Most investors in CTAs and trading systems chose those investments because of the possibility of higher returns. You can easily get no risk by investing in US saving bonds, but will you be happy with gains of just 2% per year. Probably not, and for that reason investors seek out greater returns. But they need to realize that they are also seeking higher risk.
This higher risk can show up in the form of a drawdown, and one of the hardest things is having the guts to stick through a drawdown when your right in the middle of it. Our natural tendency is to get away from something which is causing us pain (losses), and so our natural inclination is to quit a program when its in a drawdown because it just doesn't feel right. To stick through a drawdown, you need to overcome this natural tendency by making it all about the statistics. Set a line in the sand based off the historical parameters, and don't flinch until that line is crossed. That takes away the daily mental battle of whether you should stick with the program or dump it. It gives you intestinal fortitude, even if you don't really have it.
Part of the problem with an investment in trading systems is that it is too liquid. Investors can stop a system by merely picking up the phone and saying the words. An investment of similar size in real estate or a hedge fund for example, often takes more time to liquidate, causing investors to let it run its course and see the long term gains. It is important to note the corollary to things don't go UP forever: things don't go DOWN forever either. CTA programs and trading systems are very cyclical by nature, making money, then losing money, and so on. It pays to stick with a system in its downturn, because their cyclical nature leads you to believe they will come out of it.
5. Quit once the system has eclipsed 1.5 times its historical Max Drawdown.
As touched on above, you need to have a line in the sand for any investment. Without one, you will go crazy wondering whether the program is broken, if the manager knows what they are doing, and so on. It becomes an emotional guessing game as to whether you should stick with the program through a drawdown, and more times than not, your emotions will guess incorrectly and get you out at the low.
Contrast this with an investor who starts a new CTA, and knows they are going to risk exactly $xxx trading it. Until and unless their account gets anywhere close to down that amount, they are on cruise control and paying the account very little attention. That is the statistical risk, and whether the Fed cuts rates or OPEC raises production, it really doesn't matter. The account either will stay on the plus side of that risk number or hit it. You must know what your risk is for each investment.
The answer to handling drawdowns lies in this mental preparation. Investors need to know a system's past Max Drawdown like they know their daughter's birthday. Just like that birthday, they should expect to see a drawdown of equivalent size once a year, and one even bigger at sometime in the future. They should know that it will happen in their account with their hard earned money. They need to have the intestinal fortitude to stick with the program through these tough times. Finally, investors must not be scared to quit a program if it has gone through its past Max Drawdown by a significant amount. Attain recommends using 1.5 times past Max DD as a basic rule of thumb.
Drawdowns - that ugly word - are real. They are that terrible feeling in the pit of your stomach. Drawdowns happen. Drawdowns will happen again. These are the facts. Successful investors know this. They prepare for it. Successful investors are those who can handle the tough times a drawdown represents. Successful investors are those who see opportunity while others see panic or fear.
IMPORTANT RISK DISCLOSURE
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Impressive tech earnings from heavyweights like Microsoft rallied the stock market last week despite another round of debt write downs by US banks and near record high energy prices. SP 500 futures advanced +2.44% as investors continue to show faith in the US economy. NASDAQ futures +2.67% also traded higher as did Dow futures at +2.12%. In smallcap trading Russell 2000 futures +3.57% were up big while SP Midcap 400 futures +2.52% also had impressive gains.
Despite the good news from the stock market, the news headlines continue to focus on crude oil prices which are now eyeing $100 per barrel. December Crude Oil futures were up +5.65% last week alone due to concerns regarding fighting in Northern Iraq and storms in the Gulf of Mexico. The other energy markets followed crude’s lead and finished higher for the week. RBOB Gasoline futures +4.90% led the way and where followed by Heating Oil +4.35% and Natural Gas at +0.56%.
Elsewhere in commodity trading precious metals were up with Silver +4.73%, Gold +2.49%, Platinum +1.42% and Palladium +0.87% all trading higher. Grains were also volatile with Chicago Wheat prices -6.49% coming down hard off their near record highs. Soybeans +1.20% and Corn +0.47% finished the week slightly higher. Meat prices continue to fall with Lean hogs -4.22% and Live Cattle -2.24% both down for the week. Finally, the soft’s were also down with Coffee -2.84%, Cotton -1.18% and Sugar -0.59% all trading lower
. ***Commodity Trading Advisors (CTAs)***
What a difference a week makes. Two weeks ago, option index sellers were seeing open trade losses due to a bump up in volatility, but as index markets rebounded last week, those open trade losses were wiped out for index option sellers. On the flip side, the energy run up hurt commodity options sellers.
Heading into the final few days of the month, most index option sellers are slightly ahead for the month. The most successful of which has been BC Capital. BC Capital suffered a down turn in their equity in July and August but has since rebounded exceptionally well, earning +5.0% in September and approx. 2.0% so far in October. In talking with the manger, he expects the strategy to fully recover the drawdown between late this year and the first month or two of 2008.
Diversified mangers have seen mixed results so far in October. Attain Portfolio Advisors has continued its winning ways and is ahead aprox 4% for the month which brings the annual return up toward the 20% mark. While the Dighton program, which had made new equity highs in the middle of the month after its big September of up 35%, has since come back to around break-even for October. .
The hardest hit sector for the month to date has been the commodity option sellers which have found the Energy sector anything but easy to navigate. With Crude Oil hitting new highs daily the entire sector has rallied causing for open trade losses to build up on several CKP and FCI potions. FCI is down aprox 5% for the month and CKP is down aprox 15%.
Finally, the FX markets have found success in the falling dollar – looking at the stats K3 is ahead aprox 2.5% for the month and Fit FX is ahead aprox 1%.
***Day & Swing Trading***
U.S stocks overcame heavy selling pressure on Monday and Wednesday to finish the week higher. On those two days, US stock indeices were down relatively large amounts in the morning, only to see the market come all the way back on both days. Most systems got caught short on thses days, only to watch the market bounce off the lows and finish higher on the day.
Overall swing systems fared better than their day trading counter-parts. Tzar NQ made +$1,065 on its long position on strength in the tech sector. Ultramini eMD had one long trade good for +$880. Tzar ES reversed short on Tuesday’s open and made +$682.50 for the week despite currently having an open trade loss on the short position. Ultramini ES had two trades for a gain of +$440. Both Signum TY and EBL ended the week nearly unchanged after both markets consolidated near last week’s highs. Mosaic eRL had nine trades for a loss of -$730. Finally, AG Mechwarrior ES got caught up in several whipsaw trades that lost a total of -$1,145 for the week. SeasonalST programs did not trade last week after exiting profitable trades the week before.
Moving on to the day trading systems, Kappa Dax continues to be one of the more consistent systems and tacked on another +$1,860.03. BetaCon 4/1 ESX had one long trade on Friday for a profit of +$198.28. Keystone eRL was active last week with six trades for profits of +$110. OPXP eRL had two trades last week for a loss of -$70. RT Viper YM had five trades for a loss of -$410.54. Waugh eRL had four trades for a loss of -$733.33. Beta v2 Dax had one trade for a large loss of -$2,350.62. Finally, Compass SP pulled back from new equity highs with a loss of -$4,375 on four trades for the week.
Rate futures posted slight gains in a mostly sideways trade last week, although support under the market remained strong on ideas that the upcoming FOMC meeting will result in another round Fed Fund cuts. Recent weakness in U.S. economic data led by the housing sector meltdown continues to support market participant ideas the FOMC will cut rates at both the October and December meetings, especially if global equity markets underperform due to credit worries. The upcoming week’s economic releases are fairly heavy with a mixed focus, but all eyes will likely be glued to the FOMC announcement and the Monthly non-farm payroll report due out at the end of the week. Long term trend followers are still slightly positive as Aberration is currently long TYZ with a current gain of +$1359.00 (open trade).
Another week of historic lows for the U.S. Dollar versus most major foreign currencies as market activity continued to be influenced by the extended rally in inflation sensitive instruments like energies, metals and softs. News of higher interest rates in Mexico and a few other Southern Hemisphere countries due to worries of food inflation added additional U.S. dollar selling into the arena. The will be an active number of U.S. Economic releases for the upcoming week weighted more toward the inflation, but the two key events will be the FOMC meeting and the monthly unemployment report. Long term trend followers remain in a mostly negative stance toward the U.S. Dollar as both Aberration and Relativity are currently short DXZ currently making +$2270.00 (open trade) and +$2680.00 (open trade) respectively. Relativity is also Long ADZ making $3550.00 (open trade).
The soft commodity sector experienced mixed activity last week as the livestock sector was again lower along with most foods and wheat, but the corn and soybean markets continued to grind higher. The livestock and meat sector continues to find weakness from heavy supplies which as of now have even swamped outstanding export demand. The corn and soybeans continued to find upside momentum on ideas of lower than expected production in the U.S. this fall. Wheat and some other sectors of the food commodities found pressure on news of rain events in extremely dry growing areas in the Southern Hemisphere. Aberration is currently long BOZ trade with a gain of $1146.00 (open trade). Relativity is currently long SMZ making $2180.00 (open trade), Short LHZ making $4190.00 (open trade), and Long Jan Robusta coffee losing -$250.00 (open trade). Aberration was stopped out of the long KWZ making $11,532.00.
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.