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Trying to Time a System Can be Costly

August 7, 2006

What to do when a system is doing well, and (perhaps more importantly) what to do when it isn't doing well are two of the more frequent questions put to us at Attain. Many people like to take a contrarian view and not get involved with a system until it has seen some drawdown, and others have wondered aloud whether it's wise to sit on the "sideline" for a few trades when a system hits equity highs so as to miss any upcoming string of losing trades. Once this losing string is over and the system has retreated off its equity highs, these investors would then jump back in.

A similar strategy among some investors is to call up and put their system on hold before a Fed announcement, big earnings news, or my favorite - "until the Middle East calms down". Many successful investors have made money - or saved it - by following such gut instincts, and this begs the question of whether you should ever be "on the sidelines".

Skipping any upcoming drawdowns is obviously a fantastic idea, but the only way to do that is by not trading. If you're not in the game, so to speak, sure you won't lose - but you also can't win. The simple answer is NO! It is statistically improbable to "time"a system in this way.

Trying to time a system by sitting out certain days is a surefire way to negatively affect your performance. But what about earnings releases, Fed announcements, and special events? Trading systems enjoy the volatility these events provide, and often do better in times of higher volatility. The statistics show that trying to time a system, in attempts to sit on the sidelines and miss losing trades, is a losing proposition.

The crux of the problem is that you never know what tomorrow will bring. The next trade, or string of trades could be the best the system has ever seen. They could also be the worst, but the most likely scenario is somewhere between those two extremes.

To test our hypothesis, we gathered data on the performance of the Compass system over the past 6+ years. We wanted to see if the savings gained by "missing" some of the worst strings of trades was great enough to overcome the opportunity cost (missed profits) of "missing" some of the best strings of trades.

Our tests showed that the penalty of missing even a few of the most profitable trades over this time period had a severe effect on profits, while the possible savings were not large enough to justify sitting on the "sideline".

We show our results in the table below by looking at the total return of Compass over the past 5 years (+245.66%) as compared to the total return if an investor had missed the best single trade and best 5, 10, and 30 day strings of trades. We then show the total return as compared to the total return that would have been achieved had an investor missed the single worst trade and worst 5, 10, and 30 day strings of trades.

You can see that anyone unlucky enough to time a move to the "sideline" at the worst possible time — thus missing the best 5 day string of trades in the Compass system - would have seen the total return drop from 245.66% to 205.78%, or about $12,000 less in profits.

Conversely, if an investor had timed a "sideline sitting " perfectly and missed the worst string of 5 trades, the total return would have only improved from 245.66% up to 266.23%, or about $6,000. So an investor who went to the sidelines for 5 trades would have had at best saved herself about $6,000 and at worst cost herself about $12,000.

That is not the kind of risk/reward successful investors take on, and neither should you. One look at the near 100% difference between the total return and the total return if missing the best 30 day string of trades, 246% vs 150% should make you a believer.

The bottom of the table below displays the max "penalty" investors would have incurred (in the form of missed profits) on the left and the max "reward" (in terms of missed losses) investors would have saved on the right - for different periods of consecutive trades (strings of trades in 5,10, and 30 day periods) The table shows that the risk is much greater than the reward at every level, as the opportunity cost of missing a good trade far outweighs the potential benefit of missing a bad trade.

This characteristic of trading systems should not be surprising, as the majority of systems are designed this way. In the terminology of America's baseball pastime, trading systems hit "Home Runs", not "Base Hits". So they are constantly trying to survive the less than perfect conditions while waiting for that one big trade.

They are deliberately designed to lose a small amount of money on losing trades, and make a great deal more money on the less frequent winning trades. In fact, the majority of profitable systems lose more often than they win. How can this be? Because they make much more when they have a profitable winning trade than when they have a negative losing trade.

The investor attempting to miss some of the "strikeouts" will undoubtedly miss a couple of "Home Runs" in the process.

- Jeff Malec

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.

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Chart of the Week : Risks/Rewards of Timing a System

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The Week in Review

***Overview***

US stocks were all over the map in July, with several big down days mixed in with runs towards three month highs, as tough earnings in the tech sector and violence in the Middle East brought uncertainty into the marketplace. Overall SP 500 futures remained virtually unchanged for the month, but NASDAQ futures fell -4.57% after heavyweights like Microsoft disappointed investors with their second quarter earnings and/or their forecast for the remainder of 2006. Smallcaps also felt pressure with Russell 2000 futures falling -3.67% and SP Midcap 400 futures moving -3.27% lower on the month.

Energy futures were very volatile in July due to the violence in Lebanon. Crude futures hit a new all time high in mid July but gave it all back by the end of the month as the commodity fell -0.80% on a month to month basis. It was the same story in the Unleaded Gas market as gas futures rose higher before falling slightly at -0.08% for the month. The story was much different in Natural Gas trading however as Natty Gas futures rose +30.04% in July!! Long known for its unbelievable volatility, the recent market conditions in Natural Gas are some of the most volatile ever seen with near 10% swings occurring on a daily basis. Enter that market at your own (very high) risk. Finally, heating oil futures moved lower falling -2.94% for the month.

The precious metals markets began trending higher again due to a surge in demand and dwindling supply. High Grade copper futures led the charge gaining +6.41% for the month while Silver futures closed 4.12% higher. Gold futures were also up gaining +2.90%. Platinum and Palladium did not rally however with Platinum remaining unchanged and Palladium losing -1.96%.

Treasuries rallied higher as traders are beginning to forecast that the Fed will pause from raising interest rates in August. Although most traders expect the Fed to continue raising rates later in the year most feel that the market needs to catch itâ€™s breath before the next round of 0.25 increases can take place. 30 year bond futures rose +1.64% for the month while 10 year note futures were up +1.12%. Foreign currency trading was stagnant and choppy for most of the moth with Eurocurrency futures falling -0.20%, Dollar Index futures rose +0.22%, Japanese Yen futures were down -0.54% and Swiss Franc futures fell -0.83%. One market that did stand out was the British Pound which rallied +1.44% as the Bank of England announced plans to raise interest rates.

In commodity trading grains were up and down with Soybeans falling -3.654% and Corn moving -1.63% lower. Wheat futures held their own gaining +0.37%. In the tropical markets Sugar futures were the big mover falling -8.75% in July. Cotton -1.63% and Coffee -1.73% also moved lower. Finally in the meats Lean Hogs fell -1.91% and Live Cattle futures were down -0.70% in July.

***Day Trading***

Choppy trading conditions in July made for mixed results across the day trading programs. Several systems, especially those that are highly active, were hurt by huge intra-day swings that occurred on several different occasions throughout the month.

Systems that were more selective on their entries managed to come out of the month with modest profits. Omega3 v1 Dax took top honors in July with profits of +$1,696.15 for the month. Close behind was R-Mesa eRL which was tacked on +$1,007.50. Impetus eRL completed its 5th straight profitable month by adding another +$952.10 in profits in July to finish the month at new all time equity highs. Bounce eMD also finished the month at new all time equity highs, taking four trades for the month that totaled +$856 in profits.

BetaCon 4/1 ESX outperformed its sister program that trades the Dax and made +$669.20 for the month, leading all systems in percentage terms for July (see Top 10 below). The red hot Rayo Plus Dax cooled down a little bit in July, but still managed to profit +$312 for the month. Compass eRL had eight trades for gains of +$261.50. BetaCon 4/1 Dax made +$100.70 for the month. Finally, the last of the profitable systems was Bounce eRL which made +$80 on one single trade towards the end of the month.

Elsewhere, Tanker struggled to find direction in the Crude Oil market and lost -$150 for the month as Crude peppered some sharp down moves in amongst its climb higher in July, Russell Daytrade had ten trades that lost -$248.22 for the month, and Compass SP finished the month with 5 straight winning trades - but still lost -$532 in July after starting the month off on the wrong foot.

Those Eurex based systems not listed above struggled a bit in July. Theta Dax lost -$1,108.26 on ten trades for the month, Phi Plus Dax lost -$1,193.30 after taking multiple positions on a few different occasions, and Beta v2 Dax had similar results with a loss of -$2,177.13 for the month. Epsilon 12/12 Bund had its most challenging month YTD, meanwhile, with a loss of -$2,811.77. Lastly, RC Success eRL continues to be volatile from month to month and lost -$3,652.60 in July.

***Swing Trading***

The swing system of the month goes the Targets suite of systems by Traders Tactics (www.traderstactics.com) which earned a combined +$3,768.39 across the eRL and eMD markets. The system is designed to use a combination of momentum, market internals, and volume to elect its short term trades (1-3 day hold time). The system initiates each trade with 3 contracts with 3 price targets. Once the first target is reached stops on the remaining 2 contracts move to break even. Please e-mail invest@attaincapital.com for more information.

Other index systems to capitalize on Julyâ€™s market included Tzar ES +$3,077.5, Delphi eMD+$1,869.50, Spartan ES +$1,045, Tzar eRL +$455, and Bounce eRL +$250.

Noting the rapid changes in market direction it is not surprising that several swing trading systems struggled to find profitable opportunities. Those systems finishing in the Red included: Tzar eMD -$2,910, Tzar NQ -$2,841.47, Axiom eRL -$2,826, Axiom eMD -$1,570, Ping Systems -$1,192.80, Seasonal ST eRL -$1,040, Delphi eRL -$733.2, Bounce eMD -$700, Seasonal ST ES -$515, and Eclipse eRL -$390.

In the Forex markets the action seemed never to stop. Topping the charts was SC Forex GBP which earned +$1,510 on 4 trades including one profit target. Delphi EUR also posted a gain of +$170 for the month and then went on to hit a profit target last week for a gain of +$2,030 on the trade. Finally Volcano FX lost a combined -$1,256.70 on 11 trades spanning 3 different markets and Hurricane GBP lost -$1,570 on 3 trades.

Lastly, in bond trading Mesa Notes earned +$1,250 and Jaws Narrowneck bonds lost -$2,056.25.

***Long Term***

After a very lackadaisical start to the summer in June the commodity markets are beginning to pick up steam again as we hit the dog days of August.

Obviously, with hurricane season right around the corner and colder temperatures not too far away energy futures will continue stay in the focus of most traders. Unfortunately, 30% moves in markets like Natural Gas donâ€™t bode well for system investors as the market is much too risky.

However, other markets like Sugar (-8.75%), Soybeans (-3.75%), Silver (+4.12%), and Live Cattle (-0.70%) have provided good trading opportunities for trend followers.

Systems taking advantage of the big July downward move in Sugar include Trend Simplicity which is making +$846.00 per contract and Aberration Plus which is losing -$139.60 per contract on short positions. Axiom LT is also short, albeit overseas in the London Sugar contract, for a small loss of -$5.00 per contract.

Live Cattle has also been a popular market as Axiom LT is making +$940.00 per contract on a long position while Aberration Plus is making +$1950.00 per contract. Trend Simplicity just entered a long position this morning.

Finally, metals began to rally again in July and thus far systems with long positions include Trend Simplicity which is making +$3325.00 per contract in Silver and Axiom LT which is losing -$195.00 per contract.

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