The key to living through drawdowns -Stick to your Rules.
October 2, 2006
If you plan on thriving in your trading system investments, you need to become very familiar with the term drawdown, and even more familiar with how to handle one. With some systems like Axiom eMD and Rayo Plus Dax currently going through drawdown phases, it's a great time to review drawdowns.
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, and just $75,000 in her account as of the end of March has experienced a 25.00% drawdown. ($75K - $100K = -$25K/$100K = -25%)
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 either at new equity highs with your trading system 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 a lot more time in drawdown (even if its a nominal one of just $500 to $1000) than they will at equity highs.
We all look at the drawdown numbers, but when we see them in OUR account; we act like we never expected it. "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 system which prefer certain market environments to other ones.
So if you're going to spend up to 80% of your time in drawdown, you need to learn how to measure and handle it. The first lesson is to not be surprised by drawdown. By studying the back tested results carefully and basing your decision to start trading a system off the draw down and profit, you hope history will repeat itself. If it does, you stand to make a good profit. If you want history to repeat, don't be shocked when the draw down happens again. The drawdown is just as much a part of the history as the profits.
While everyone looks at the statistics of various trading systems, how many really prepare themselves for the inevitable drawdown. The Compass system, a popular choice among many investors at Attain, experienced a 52% drawdown in 2002, losing money in 4 straight months, and a 54% drawdown in 2004. Could you handle losing over 50% of your capital, and still have the faith needed to continue taking the system's signals? I know first hand that 3 out of 4 investors who experienced those drawdowns didn't have the faith to continue, and as such missed the system returning 183% over the next 21 months following the '02 drawdown and 50% since the '04 drawdown.
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. An investment in mechanical trading systems is no place for emotional decisions. In fact, the very strength of trading systems is their ability to eliminate the losses caused by emotional decisions.
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. 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 system through these tough times. Finally, investors must not be scared to quit a trading system if it has gone through it past Max Drawdown by a significant amount. Attain recommends using 1.5 times past Max DD.
1. Know a system's past Max Drawdown like the back of your hand. Know that it will happen in your account in the future.
2. Be properly capitalized to handle a similar drawdown.
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.
4. Have intestinal fortitude. There's no such thing as risk free returns, and the larger returns you expect from trading systems will come with larger risk.
5. Quit once the system has eclipsed 1.5 times its historical Max Drawdown.
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. 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.
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.
For more information, email invest@attaincapital.com
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 |
***Overview***
US Stock futures had a fantastic month in September as traders continue to be very bullish on the US Stock market. Great economic reports along with another impressive round of earnings news propelled the Dow Jones Industrial Average to near record levels throughout the month, and even the most staunch market bears seem impressed at this point.
SP 500 futures gained +2.17% for the month while NASDAQ futures gained an even more impressive +4.32%. Unfortunately for small cap traders most of the money was flowing into Blue Chips which prevented the small cap indexes from taking off. Russell 2000 futures were able to grind out modest gains at +0.60% while SP Midcap futures remained at a standstill climbing 2.30 points for the entire month.
One question many traders were asking is where is this new money coming from? What is fueling this market rally? For many investors the new money came from the commodity markets, which until September have enjoyed numerous rallies in sectors like energies, metals, and meats.
However, the tune changed quickly this month with many traders taking generous profits on long commodity positions that they held throughout the summer. The energy markets were hit the hardest with Natural Gas futures leading the way at -26.85%. This incredible sell off came as a surprise to many professional traders and was exacerbated by the collapse of a major hedge fund. The other energy markets were right behind Natural Gas as Crude Oil futures fell -11.69%, Unleaded Gas futures were down -14.95%, and Heating Oil futures lost -15.59%.
Metals were also hit hard with Silver futures falling -11.44%, Gold futures were down -4.73%, Platinum dropped -8.87% and Palladium lost -9.26%. In the meats Lean Hogs were down -5.84% and Live Cattle futures moved -3.28% lower. Other markets with big downward moves include Sugar which fell -7.99% and Cotton which was down -8.41% for the month.
Grains were the only sector to stage a rally as crop estimates continue to be dismal around the globe. Wheat futures climbed +4.91% due to weak estimates in Australia while Corn prices were up +7.25% for the month. Soybeans did not follow suit however falling -1.48%.
***Day Trading***
September was a tough month for trading systems in general, but particularly trying for day trading programs. Historically, September has been a profitable month for day trading systems as it has often been associated with huge slides in the market but the slow grind higher and a drop in volatility paved the way for losses for most of the programs this time around. Here's hoping for better times in October.
There were a handful of systems that made it out of the month with profits. Kappa Dax took top honors for the month with profits of +$1,703.80. BounceMOC eRL had just one trade in the middle of the month that gained +$850. In the same family of systems, BounceMOC eMD took at stab at three trades for the month and profited +$174.10. BetaCon 4/1 Dax and BetaCon 4/1 ESX were profitable by +$171.09 and +$142.18 respectively.
Phi Plus Dax struggled in September and finished with a loss of -$368.97. Epsilon 12/12 Bund was active as usual, only taking off a few days of the month and lost -$887.72. Tanker CL had three trades for a loss of -$1,080 despite a huge downturn in energy products across the board. Impetus eRL lost -$1,143.80 as it pulled back of its equity highs slightly.
Omega3v1 Dax was particular about its entries with only 7 trades but lost -$2,081.68 for the month. RC Success eRL had 15 trades for a loss of -$2,516.30. Rayo Plus Dax had 14 trades for a loss of -$3,485.54. Betav2 Dax was the most active system for the month, but lost -$3,837.64. Finally, Compass SP lost -$4,629.15 for the month.
***Swing Trading***
Swing trading systems come in all shapes, sizes, and most importantly time frames for evaluating the market. After reconciling last months activity it was interesting to note that the systems which performed best were those that used a longer time frame for analysis and traditionally trade less frequently.
Last month's systems of the month included Tzar 4 market US portfolio and Mesa Notes. Tzar pulled in a grand total of +$8,788.50 on 13 trades of which $4,201 came in the eRL market. Across the 4 US markets (eRL, eMD, NQ, and ES) Tzar is up +$40,140 for 2006 net of all fees! As for Mesa Notes, it too is a tried and true program that not only performed well in September but is also ahead for the year. Mesa Notes earned +$3,212.50 in September on 2 trades and is up +19% for the year based on a $30,000 account.
Other positive returns for the month included SC Forex +$2,850, Targets eMD +$2,593.35, Bounce eRL +$1,640, Volcano FX GBP +$1,630, Volcano FX EURJPY +$1,549, Pivots SP +$1,075, Seasonal ST eRL +$880, Bounce eMD +$870, and Seasonal ST ES +$185.
Of the systems that did not fare as well in September it is important that most operate on a much shorter time frame (i.e 15, 30, 60 minute charts) which in turn results in more trading and potential rapid changes in direction. The systems that were most affected include Axiom eMD -$2,588.10, Delphi EUR -$2,440, Delphi eMD -$2,321.40, Eclipse eRL -$2,230, Delphi eRL -$1,905.10, and Axiom eRL -$340. Although the above strategies did not fare well in September the potential for a swift rebound is always present and driven on a rapid change in direction that turns into a consistent trend.
***Long Term***
You may be surprised to hear that long term trend following systems are enjoying the recent downward movement across nearly all the commodity market, but unlike stocks - it doesn’t matter whether the trend is up or down for trend followers, as long as there is a trend in the market. This is the beauty of futures and trading systems as investors have the ability to profit in any market condition. So, as you might expect the recent big downward moves in energies, metals, meats, and soft’s have been a blessing for trend following systems and traders.
One market that has quietly had a real nice downward trend is sugar. Sugar, which is used in ethanol production, has enjoyed a bumper crop as farmers try an take advantage of higher prices caused by this commodities use in fuel production. Sugar prices are still historically high but they are falling fast and short positions are proving to be very profitable. Systems with short positions include Aberration Plus which has open trade profits of +2839.60 per contract and Trend Simplicity which has open trade profits of +$431.60 per contract. Axiom LT is holding short in the London Sugar contract and is losing -$1150.00 per contract.
Another market that has quietly had a nice downward trend is Cotton. Cotton futures fell -8.41% for the month and this trend has also been caught by several systems. Axiom LT has been short in this market for some time and is making +$5650 in open trade profits. Trend Simplicity is also short and making +$725.00 per contract in open trade profits, Vivaldi is short for open trade profits of +$2780.00 per contract, while Aberration Plus is short and losing -$50.00 per contract.
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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.