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The Compass Drawdown - Is it time to Worry? Time to Stop?

June 21, 2004

 

Poor Compass…..The system which has hung its hat on consistency and year after year of profitable operation is in the midst of its worst drawdown in history.

The numbers don't look pretty — Compass is down over 43% YTD, and is in the midst of a 5.5 month, 44% drawdown which started in mid January and hit a new low on May 21st. (When $50 commissions are taken into effect, the system never made new equity highs in January, and remains in a 12 month long drawdown begun last July which eclipsed 60% on May 21)

These numbers are far from the system's average annualized gain of close to 50%, and investors want to know…..Is it time to worry? Is it time to stop? The short answer is it is definitely time to worry, but not quite yet time to stop. When including commissions, the current drawdown now ranks number one in both size and duration, eclipsing the 2001 drawdown by just over $3,000, or 12%.

The rule of thumb is to always expect the worst drawdown will occur in the future, but what is one to do when the future is now? What is a normal excursion beyond the previous max drawdown, and what level of new drawdown might signal that the system is "broken" and should be reevaluated.

Let me first say that system's don't "break". No system simply stops working and starts losing money recklessly- what many investors refer to when saying a system "breaks" is when the risk profile moves severely outside of what was expected in first getting into the investment. If one of the premises for investing in the system was a Max DD of only 40%, for example, then the possibility of future drawdowns of 75% should cause the investor to reevaluate.

So if systems don't break, what do they do? They simply become much more risky. So reevaluating your system investment doesn't necessarily mean stopping it, rather analyzing whether you're comfortable with the added risk. The new profile of the system may simply mean a higher allotment of capital to the system or a reduction in exposure to the system (i.e. 2 contracts down to 1). If the system's overall metrics remain very good, stopping a system simply because it has eclipsed its max DD could do more harm than good. For example, despite this year's poor performance, Compass still averages an annualized rate of return over 40%. Its hard to dismiss that because of a new max DD.

Measuring Future Drawdowns:

But let's return to the question of how far past the old drawdown is too far past. Attain Capital has long held the belief that setting the bar at 1.5 times the predetermined, tested, historical drawdown gives a system plenty of "breathing room". This figure was based mainly on the real-time experience our team has had with hundreds of different systems, but admittedly had issues in so far as it was an arbitrarily picked number.

Attain has since set out to evaluate new and different measures of expected future drawdowns. Again, we should always expect a new max DD in the future, thus want to be prepared for that eventuality when it arrives by calculating an estimated future drawdown.

The first method of measuring a possible future max DD was to run a Monte Carlo simulation using monthly Compass data. The simulation, run 5000 times over 1200 months (100 years), randomly shuffles existing data to give probabilities of future drawdowns exceeding certain levels. Our simulations told us that 99% of the simulation trials saw drawdowns less than 65%, meaning the current drawdown of over 60% when including commissions is close to a 1 in 100 year occurrence for the system - but not there yet.

The next method was to run an empirical test on available data using the mean, standard deviation, and skew of monthly returns to calculate a drawdown estimated to occur with a 1 in 100 year frequency. These tests allow us to calculate both a Max DD in dollar terms and an estimated max drawdown duration. The empirical test showed we are close to the 1 in 100 year levels, but not there yet, with the estimated max drawdown being approximately $3,000 away in both the pure equity curve scenario and commissions included equity curve.

So here we stand, with Compass having lost money in nine out of the past twelve months, and five out of six so far in 2004. The drawdown stands at 44% on the pure equity curve, and 62% on the commission adjusted curve. By all accounts it is a time to worry. But, as shown in the table below, the system has yet to reach the estimated drawdown levels for either the pure equity curve or commission adjusted curve which would signal its time to stop.

The table below shows the current Compass drawdown as measured on the pure equity curve (without commissions) and on an equity curve including $50 in commission per trade. The estimated stop trade/reevaluation levels as derived from each of our three methods are also listed, with the average of the three shown. As can be seen, the 1.5 times tested max DD is a relatively valid measure, as it quickly and easily gives an estimated future drawdown close to the more mathematically advanced methods.

Investors can choose which method they wish to ascribe to, or use the average of the three to measure what point they should stop trading Compass or reevaluate their trading.

If these levels are hit (they are only about $3,000 away), and it does become time to reevaluate your investment in Compass, consider the following table, which shows the estimated future Max DD when including the data of the months comprising the current drawdown. You can see that the estimated future drawdowns jump higher, and show nearly $12,000 in further drawdown before 1 in 100 year levels are eclipsed.

One can not validly keep calculating these levels with current data, however, as the stop trade levels become a moving target - and one which may never get hit. This makes it paramount that investors determine their stop trade/ reevaluate levels before starting trading. If you failed to do so before starting the system - don't worry, the averages in the first table above should hold for nearly all investors who currently trade the system. Do worry about how close the system is to those levels, however. Good Luck Compass! You need it.

Jeff Malec