Avoiding the Hot System Part II, Investing in a Loser.
May 17, 2004
Something in our human makeup makes most people love to bet on a winner. Witness the record TV ratings and record dollars bet on America's new sweetheart, undefeated racehorse Smarty Jones, this past weekend. It appears people love not only betting on the favorite, be it horse racing or investing, but are especially fond of something which has never lost.
Unfortunately for investors, there is no such thing as an investment which never loses. Anyone who tells you different is selling something. Indeed, we wrote in this space one month ago about the pitfalls awaiting those investors looking to invest in the next hottest thing by jumping on the best performing systems of the last month, quarter, or year. You can view that article by clicking on the following link: http://www.attaincapital.com/alternatives/alt_apr1904.htm.
So what is an investor to do? Leave these high-flying investments alone? While staying away from the "next best thing" may be prudent until they go into a drawdown, it is the next step which is the hardest to do - actually investing with a system in a drawdown.
The not-so-obvious corollary to jumping on the next hot system is investing in a system which has underperformed recently. If the chances of making money immediately after a system has set the world on fire are low, perhaps the chances of making money immediately after a system has performed poorly is the answer. While our genetic makeup may prohibit us from accepting such a strategy as valid, contrarian investors tend to prove the majority wrong time and time again.
The argument for investing with a system in a drawdown is the exact opposite of the argument for staying away form a system hitting new equity highs, but centers on the same logic that all things return to the mean. In layman's terms: "what goes up must come down", and the less often heard "what goes down must come up".
Unlike stocks or funds, a trading system investment won't benefit from increased money flow. The system operates independently, crunching its technical formulas on the current market environment, whether that market be soybeans or S&Ps. The problem(or benefit) inherent in a mechanical system 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.
What is the bane of the hot system is the gain for the beaten down system. As mentioned in the month ago piece, these environments change. Governments, economic cycles, weather, science, and people change the way the world goes round every day, causing the specific environment your system likes to either be in or out of phase. A change in environment could be just what the doctor ordered for a system in a drawdown. The tough part, as always, is knowing just when that change occurred.
The benefit of investing in a beaten down system is that the system has most likely just lived through one of the least desirable market environments it could imagine. With conditions failing to line up for the system - it just didn't do well. Will things continue to go against that system? Will market conditions NOT change? Don't bet on it. To the contrary, bet on them changing.
The chart below shows the worst returns for six systems over a monthly and quarterly period and the corresponding returns for the following months and quarters. There are two systems of each type: day trade, swing trade, and long term; to give us a good cross section of different systems. Each of these systems has suffered through a beaten down phase, and lived to tell about it. Did it pay to jump on that "beaten down" system for the next month or quarter?
The data is mixed on the benefits of getting involved in a system in a drawdown. The average of the months following each system's worst months was telling, showing an average monthly gain of 6.57%. The average return in months following losing months was not as impressive, however, with an average loss of -0.67% in months following a monthly loss.
The quarterly numbers weaken our argument further, showing negative returns in the quarter immediately following the worst quarter, and showing negative returns in the average quarter, and average next two quarters, following a losing quarter. This data would suggest it does not pay to invest in a system in drawdown, in that negative monthly and quarterly returns beget more negative returns.
However, a closer look at the numbers show this data is skewed a good deal by one system - LTS Breakout. This system, as many readers know, was pulled off the recommended list by Attain Capital upon breaching its tested max drawdown by 150%, but was still traded and tracked by some investors down to a nearly 95% drawdown. .Another statistical anomaly is at work as well, in that some of these systems have track records shorter than 24 months. The abbreviated track record leads to downward skewed averages.
To combat these statistical skews, we ran the same test on the 11 year track record of CSFB's Managed Futures index, as well as recalculated the system averages excluding LTS Breakout. These results were more in line with our expectations of positive returns following negative drawdown months and quarters, with the Managed Futures Index showing an average monthly gain of 0.41% after losing months and the all system average without LTS Breakout showing a 1.29% average gain over the six months following losing quarters.
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 are 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.
Trading systems don't like surprises, and the sharp reversal Wednesday showed why that's the case. With the Dow down over 175 points and many systems holding short positions, the US stock market had its sharpest reversal of fortune in the past in 14 months, as S&P futures moved from down 16 points to up 4 points in just over two hours. The rally stopped out system after system on the way up, making for a less than ideal week of trading. Only R-Mesa was able to profit from the move, reversing long to capitalize on the move to the upside.
The headline grabbing market continued to be Crude Oil, however, as the futures hit record highs almost daily as concerns about supply and instability in Iraq continued to pressure prices higher. Several long term systems continue to hold long the energy complex for profits.
***Day Trading***
Despite a skimpy 27.20 point weekly trading range a couple day trading systems were profitable. R-Mesa 5 SP led the way with profits of +$900.00 per contract. Most of R-Mesa’s success can be attributed to a key reversal on Wednesday afternoon’s market rally that netted the system $3050.00 in profits. Blue Wave Zones SP was also profitable taking in +$575.00 per contract after trading six times last week. Cobalt NQ brought up the rear in the profits department making +$60.00 per contract in e-mini Nasdaq trading.
The rest of the day traders succumbed to the market and finished the week in the red. The recently popular Helix SP system has found trading a little more difficult in its second month at Attain as it lost -$2845.00 per contract after 10 trades last week. For the month Helix has lost -$4545.00 per contract. Day Breaker SP also had a tough week losing -$2250.00 per contract, and is also down for the month - losing -$2239.00 per contract.
Finally, e-mini traders RC Success ES, Sniper ES, and Impetus e-RL also took losses with RC Success losing -$250.00 per contract, Sniper ES losing -$820.00 per contract, and -$252.00 per contract.
***Swing Trading***
Day traders weren't the only ones cursing Wednesday's sharp reversal. Swing trading systems saw their nice short profits disappear as well.. On the closed trades, I-Master NQ was the only profitable swing system making +$100.00 per contract last week. Other systems that traded include I-master ES which lost -$1430.00 per contract, I-master e-RL which lost -$450.00 per contract, Delmar e-RL which lost -$1230.00 per contract, and Tzar ES which lost -$1380.00 per contract.
***Long Term Trading***
The Energy complex, which includes crude oil, heating oil, unleaded gas, and natural gas markets, continues to be the topic du jour amongst traders and the general public. Fueled (no pun intended) by media speculation of $3.00 per gallon at your local filling station, and a seemingly worsening situation for U.S. interests in Iraq, energy prices have shown no sign of weakening in the near future.
Most system traders aren’t complaining though. Highlights include Andromeda hitting its $10,000 windfall profit target on a long crude position. Checkmate, meanwhile, is holding long in the crude for open trade profits of +$2450.00 per contract, heating oil for open trade profits of +$2045.80 per contract, and in natural gas for open trade profits of +$1810.00 per contract. Trendchannel is also long in the crude making +$5110.00 per contract.
A wet humid week across the Midwest led to several significant moves in the grain markets including a locked limit down move in the soybeans on Friday. Soybeans which were trading on record high’s this past spring seem to be finally moving lower in anticipation of decreased demand throughout the summer. Catscan is one system trying to catch the downward move and is currently holding short for profits of +$675.00 per contract. Finally, Synergy took its grain profits off the table exiting as short corn trade for profits of +$2512.50 per contract.
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.