The Paradox: Losing money with a profitable system.
September 7, 2004
It seems as if it never fails to happen. Is it bad luck, or some form of Murphy's law (what can go wrong will go wrong)? Its hard to tell, maybe some investors are just destined to lose money, but each year there is a tough luck story of investor or two who loses money trading a profitable system.
This year's nominee has to be an Attain investor who stopped the Helix system after it took a $2,075 loss on July 20th - its fifth loss in a row and 11th loss out of 19 trades at that time in July. The system was in a drawdown of approximately $13,000 per contract and she had seen enough, despite her prior admissions and emails saying she understood the system had drawdowns of over $30,000 in backtesting.
Well, as luck would have it, Helix went on to make approximately $2,200 the rest of July and $18,070 in August. Our poor investor called in the other day wondering how the system could have done so well after looking so bad in July, and became so distraught over the missed profits she closed her account.
What causes us to behave in such ways. How can we let emotions into a system trading realm which is ruled by mechanical, non-emotional decisions. The disconnect occurs at the portfolio, or asset allocation, level. While the actual trade by trade decisions of a system are mechanical and consistent, the decision to start or stop a system is still predominantly an emotional one.
Attain has found the decision to stop trading a system becomes more emotional and ill-timed the more an investor "watches" their investment. This makes sense given that most systems make money on only about 35% to 50% of their trades, meaning a trading system investor watching every trade will be disappointed in what she sees the majority of the time.
The following discussion, including the statistics and numbers within, can be directly attributed to Nassim Taleb, from his excellent book, Fooled by Randomness, Texere, LLC Publishing, 2001.
Many investors believe if they had an investment which had a 93% probability of making money each year, they would have found the holy grail. Such an investment would be ideal, and put simply would mean that roughly nine out of every ten years would be profitable.
Consider the troubling idea that a grand majority of investors involved in such investments ultimately lose money. How can that be? - you ask, when there is a 93% probability of success.
Many investors lose money trading systems for the simple fact that they get too close to the action. The great majority of what goes on in a normal trading system account is just noise - with small losers, winners, break even trades, and more going on a daily basis.
Investors who zero in on this noise, instead of the end result can fall into the very dangerous trap of judging their investment too soon. It is the investing equivalent of 'judging a book by its cover', and can lead to an investor stopping a profitable trading systems.
Consider the investor who enjoys a "15% return per year, with 10% volatility per annum. This translates into a 93% probability of making money in any given year. But seen on narrow time scale, this translates into a mere 50.02% probability of making money over any given second."
The investor who checks this account on a second by second basis has no chance of long term success. The investor will be an emotional wreck: "…each day he will have 241 [profitable] minutes against 239 [non-profitable] ones." They will jump off systems at the wrong time, and jump on new systems at equally poor times. They are investing based on the noise, not the facts.
As many investors will attest to, a non-profitable minute (or day) causes much more harm, than a profitable one causes benefit, thus even though the minutes are almost evenly spaced, the emotional drain of all those non-profitable minutes will start to weigh on the decision maker. The result will be an emotional decision to stop trading a system which has a high probability of long term success.
The investor who looks at her statements on a daily basis will have 167 days in which they need to mentally handle losses, versus 197 enjoyable statements. Compare this with the investor who only checks her statements on a monthly basis, being challenged by losses only 4 times out of a year. Now consider this same account, viewed on a yearly basis, would have positive returns on the statement 19 out of 20 years, or 93% of the time. This investor would be crazy to stop the investment, for fear of not enjoying the next 19 profitable years, but the investor who quits after 2 out of 3 losing months deems herself wise.
It goes against human intuition to believe that something which can be witnessed losing money 50% of the time on a daily basis will make money 93% of the time on a yearly basis. It just doesn't seem to make sense, and the reason it doesn't is it's caused by randomness. There is simply a lot of random noise present when viewing performance on a daily basis, and it is extremely difficult to filter out this noise.
The following table shows the probability of viewing a positive return in an account which makes a 15% annual return with 10% volatility at different time intervals.
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.
Feature | Week In Review | Chart of the Week |
Feature | Week In Review | Chart of the Week |
Except where noted, the below Profits/Losses based on closed out trades. $50 per R/T commission included ($30 per emini) Percentage gains based on developer recommended initial balances as listed at www.attainaccess.com.
What a month! So much for the low volume and low volatility many traders complained of during August. Day traders shrugged off the supposed "less than ideal" climate to post huge numbers last month, with twelve out of thirteen day trading systems seeing positive returns for the month.
Systems such as Helix SP, Compass SP, and R-Mesa SP rebounded with positive returns, while other systems like Blue Wave 3.0 posted profits for the second month in a row. Overall, the SP index as a whole was not very active from a monthly perspective as the index only finished 0.27% higher, although there were several large intra month moves. The tech laden Nasdaq continues to weigh on the overall market finishing in the red once again down -2.3%.
The lack of trends in the index markets were troublesome for the swing traders, however Tzar and Axiom did post gains in a couple markets. Finally, several of the long term systems bounced back into the black after catching trends in the U.S. Bond, foreign currency, and energy markets.
**Day Trading**
“What goes around comes around.†This must be what Helix investors have been saying to themselves the last couple months after witnessing how volatile day trading SP futures can be. After posting returns of $20,740.00 per contract in April, Helix lost a combined -$16,281.50 per contract in May, June, and July, only too bounce back with gains of $16,270.00 per contract last month. Whew! It was quite a ride but those investors who were able to ride out the drawdown prevailed as Helix was our top performer in August.
Helix was not the only system to post impressive gains. Blue Wave Trading's Zones 3.0 took profits of +$8217.50 per contract as the developers upgrade seems to be working in the current market conditions. BWT 2.1 was not far behind with profits of +$7112.50 per contract. While version 3.0’s returns are good, the gains posted by BWT 2.1 may be even more impressive when considering the drawdown the system was in prior to August. This statement can also be applied to Compass and R-Mesa investors as both of these systems entered August in drawdowns before positing profits of +$5098.75 per contract and +$3560.00 per contract respectively. Cipher ES also enjoyed a great month posting returns of +$3007.50 per e-mini SP or +$15,037.50 for those customers who trade five e-mini contracts.
Other systems that posted gains in August include Daybreaker SP which made +$250.00 per contract, Magnitude ES (+$675.00), Impetus e-RL (+$405.00 per contract), Cobalt NQ (+$260.00 per contract), and RC Success (+$257.50 per contract). Finally, the only system that was not profitable was AG-Xtreme, which lost -$1200.00 per contract.
**Swing Trading**
Although market conditions were great for intraday systems the swing or inter-day systems where hampered by choppy market conditions on a day-to-day basis. Two systems that performed very well were Tzar ES and Axiom SP. Both of these systems seemed to time the SP market trends perfectly with Tzar ES posting gains of +$2810.00 per e-mini and Axiom SP taking profits of +$3725.00 per contract. Tzar e-RL also performed well with returns of +$610.00 per e-mini Russell contract but Tzar NQ remained in the red losing -$55.00 per contract.
I-Master struggled in all four markets ES, NQ, e-RL, and e-MD. I-master ES had small gains of +$47.50 per e-mini contract, but the system lost -$500.00 per contract in the NQ, -$710.00 per contract in the e-RL, and -$850.00 per contract in the e-MD.
In bond swing trading Mesa Bonds finally closed out the long position it had been holding since early June for gains of +$6303.70 per contract. Over this time period the U.S. Bond market rose over 7% and Mesa Bonds unbelievably caught nearly 87% of this upward move on one trade! Quite a turnaround for a system many investors thought was broken in April. For the month Mesa Bonds had returns of +$6388.70 per contract while Mesa Notes lost -$2727.50 per contract.
**Long Term**
Long term system investors have been looking forward to the return of trending markets for nearly six months, and although trends were limited once again in August some market moves were prevalent. As we mentioned above, U.S. Bonds continued to trend upward gaining 4% in August, while Eurodollars were up 1.9%. Nearly all the long term systems are holding either 30 year bonds, 10 year notes, 5 year notes, or 2 year notes long including Andromeda, Synergy, Checkmate, Aberration, Trendchannel, LaJolla, and Brix. Eurodollar positions are less popular with only Trendchannel holding long.
Energy futures continued to grab headlines in August. Crude Oil futures actually fell -1.26 % in August and many analysts are expecting another drop in September. Trendchannel and Brix continue to hold long in the commodity. Natural Gas futures made a more drastic move to the downside falling an unbelievable -18.41% in August. Although those with experience trading natural gas were not fazed as tumultuous spikes are common in this market. Andromeda took full advantage of the move by hitting its profit target on a short trade and making +$9950.00 per contract while Checkmate is currently holding short.
Finally, foreign currencies were for the most part choppy with Eurocurrency rising 1.35% and Canadian dollars rising 1.48%, while Dollar Index futures fell -1.27%. Profits have been tough to come by in these markets and Dollar Trader has been the worst performer losing -$5587.50 per contract in the EC and -$687.50 per contract in the Japanese Yen.
Please Login to: http://www.attainaccess.com for the latest updated statistics.
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.