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What's Wrong with Compass? ...........Nothing!

April 12, 2004

 

Was it the November 3rd newsletter asking this same question which pulled Compass out of its 5 month 2003 drawdown? Compass had been down 25%, and was in the midst of an 86 day drawdown when we answered the question of what's wrong with Compass with a resounding: NOTHING. Twenty days later, Compass hit what would become the low point of that drawdown on November 25th, setting its Max DD for the year at 30.66%. A short two months later, the system emerged from the drawdown as a winning trade of $900 on January 27th sent the system to new equity highs(excluding commissions).

Unfortunately, we don't live in a world without costs, and the true Compass equity curve including commissions never emerged from drawdown in January(missing it by just a few dollars) Well, wishing for a bit of that "Newsletter Luck" we instilled on the system last time, and fielding our fair share of questions asking "What's wrong with Compass?" - we decided to ask the question again and revisit the statistics.

First the facts: After hitting a new equity high in July of 2003, the venerable Compass trading system has fallen on hard times of late, losing money in 6 out of the last 9 months. The July to April drawdown has lost more than $12,000 and currently stands at -42.90% on the developer's recommended initial balance of $30,000.

Despite the system's four straight years of positive performance, many investors have started wondering what's wrong with Compass lately. The quick answer is NOTHING.

Investments go up and down, and this happens to be one of the down periods for Compass. There is an old saying on the trading floors of Chicago that trees don't grow to the sky, meaning simply that profits do not keep coming, month after month, forever. There are times where all investments take a break and go sideways or down for a period, before possibly returning higher. Statistically speaking, this appears to be one of those times.

Of course, there remains the possibility that a trading system will never return to profitability, and the losses will just keep coming. So how can you tell when a system is experiencing the normal swings of a trading system investment, and when it has stopped working altogether. A proper measurement of all aspects of the drawdown is essential.

Most investors do a thorough investigation of a trading system's maximum percentage drawdown(the magnitude) - but fail to consider the length of that drawdown. In our speed obsessed society where the latest news can be beamed to your cell phone and packages are shipped overnight across continents, many investors take a "Perform Now" stance. Our experience has shown these "perform now" investors inevitably end up getting in at the top and out at the bottom. Patience, it turns out, is more than a virtue - it's a requisite for investing success.

In the end, you must tackle the stats. You must know where the current drawdown ranks among historical drawdowns for the system, what the maximum expected drawdown is, and what length of time you can expect between equity peaks.

Excluding the effects of commissions, Compass currently stands $12,870 from its last equity peak in July of last year, representing a Max DD for the year of 27.25% on the developer's recommended initial balance of $30,000. The length of the drawdown, or time between equity peaks, currently stands at 195 days and counting.

While no one likes to see losses, if they must be encountered it is best to see them within the parameters of the system. So Attain looked back at every trade of the Compass system between March of 2000 and April of 2004 to see where the current drawdown ranked among the system's past drawdowns in both magnitude and length.

The results showed this drawdown is within the system parameters as far as size is concerned, but has exceeded historical levels for length of drawdown. This drawdown ranks fairly high among Compass' 35 drawdowns, as Compass averages just over 20% per drawdown and just under 23 days between equity peaks. However, the system has had a history of at least one fair sized drawdown in each of the four years since release at approximately 20% or higher and over 50 days in length.

The chart below shows the ten largest drawdowns experienced by Compass and highlights the current drawdown in yellow. All percentage figures are based off the developer recommended initial balance of $30,000.

While the current drawdown is worrisome, ranking highest in length and 2nd highest in magnitude, Attain contends it is not time to worry yet. Our belief is that a system should not be stopped until 1.5 times the "pre-set" historical tested drawdown is met. This can be a moving target once you are in real-time trading, thus it is extremely important to "pre-set", before any drawdown is met, the stop trade level or line in the sand. The number Attain uses as a basis for this comparison is the 2001 Max DD of approximately $15,000.

At the end of the day, Compass remains a proven system, now in its 5th year of real-time trading, with all 4 previous one's having been profitable. We have no reason to believe this year will be any different, and will not question the system until it has surpassed 1.5 times it previous max drawdown, which is approximately $22,500 per contract - or another $10,000 from current levels.

A Great Time to Get Started?

It is admittedly a tough sell, but for those investors looking for a bit of a bargain, the current Compass equity curve represents a great time to get started with the Compass system. Starting a system in a drawdown is a low risk proposition, considering you can set your stop trade level at 1.5 times DD, and risk only that amount with the system. If the system continues to lose and hits levels where Attain would recommend quitting the system, the investor who starts trading now has only lost approximately 33% as compared to those investors in from the beginning who have suffered drawdowns of over 70% (if 1.5 times Max DD is hit). On the return side, that relatively small risk ($10,000 in this case) could generate over $20,000 per contract in profit should the system return to its winning ways and yearly averages.

Unfortunately, most trading system investors bring their emotions into the mechanical world of trading systems by starting a system at equity highs and quitting a system at equity lows. The numbers in the table below show many would be better off doing just the opposite of that. The far right columns of the table below show the Compass system's performance in the three and six month periods after the system ends its drawdown by making new equity highs, as well as the performance over the same time period from the drawdown valley.

The table shows that those investors with the mettle to survive the Compass system's drawdowns have been handsomely rewarded in most cases, with average gains of 20.70% at three months and 46.64% at six months after making new equity highs and ending the drawdown. The opportunity which now exists with Compass is represented by the far right two columns, which show the returns from the low point of the drawdown to the levels 3 and 6 months after the end of the drawdown.

Assuming we are at the Max DD valley currently, and Compass makes a great comeback to end the year on its annual average return of 51%, those starting the system now could stand to make approximately 75% ($22,000) for 2004 for a risk of just 33%, or $10,000. It's hard to beat that risk/reward profile.

In conclusion, there is nothing wrong with the Compass system; and in fact this represents a great time to get started. The current drawdown should be viewed as nothing more than the normal progression of this trading system, or as a little bit of down to go with the up, eventhough it has been longer than may be expected. .

There is of course the ever-present chance of continued losses and new Max drawdowns, but I believe this drawdown should be viewed as an opportunity instead of a pending collapse. If this drawdown is the dip in the equity curve before heading higher, this marks an excellent opportunity for those investors thinking of investing with the system. If things go poorly - your risk need only be the difference between the current drawdown levels and slightly past the historical Max DD levels. If things go well, you have escaped the majority of the drawdown while realizing all of the upside.

For those currently trading the system, the line in the sand has already been drawn, and until that point in time comes, let the system do what it was designed to do. It was not designed to win on 100% of its trades, and will never do so. It has winners, and it has losers, and will have periods where it has many more losers than winners. Living through those times is paramount to your long term success.

-Jeff Malec