The R-Mesa Drawdown - Is it time to Worry? Time to Stop?
September 26, 2005
What has happened to R-Mesa? The system which has hung its hat on consistency since its release in 2002 is in the midst of its worst drawdown since release. Since Attain began tracking the actual client fills on the system in August of 2002, R-Mesa has had an uncanny ability to make new equity highs — hitting 10 new equity highs in the first 27 months after it was released.
The pattern seemed to be a new equity high, then about 3 or 4 months of losses down to a drawdown low, then another 2 or 3 months up to a new equity high. In fact, when excluding the months where the system made new equity highs in consecutive months - the average time between equity highs was just a little over 5 months.
But here we are sitting at 11 months since the last equity high and a new post-release Max DD of -57.60%, or ($17,280) based on the developer's recommended initial balance of $30,000; leaving investors asking what is going on with R-Mesa.
The numbers don't look all that good - R-Mesa is down over -49.4% YTD (-46% after today's $800 winning trade), and is in the midst of an 11 month, 57.60% drawdown which started in early November of last year and hit a new low last week on Thursday.
These numbers are far from the average annualized gain of 41% the system sported coming into 2005, 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 still quite far away from it being time to stop. For one thing, the system has not even eclipsed the Max DD of 63.70% seen in its pre-release hypothetical testing.
So its a little early to be thinking of stopping the system when it hasn't even pushed past its tested Max DD. The rule of thumb is to always expect the worst drawdown will occur in the future. But this begs the question — when should you stop trading this or any other system?
Setting a "Line in the Sand"
At the risk of sounding too vague, the question of when to stop trading a system is a personal one. Each investor utilizing R-Mesa or any system for that matter, should have a "line in the sand" which they will not go past. This is not the Nasdaq in 2001. We're not interested in trading something all the way down to zero, thus it is extremely important to know what your max loss point is BEFORE getting involved with a trading system.
But where do you set that line in the sand? Usually not a the pre-tested Max DD, as we can expect that a new Max DD will occur in the future. But then how far past the old Max DD. 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 starts throwing out rogue trades and losing more than it was designed to because of some broken logic or flawed code. (At least no system executed for clients at Attain). I believe 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, R-Mesa still averages an annualized rate of return over 15%. Its hard to dismiss that because of a new max DD.
Measuring Future Drawdowns:
But let's return to the question of where should you put that line in the sand? How far past the old drawdown is too far past? Attain Capital has several statistical methods to calculate the "line in the sand", but setting the bar at 1.5 times the predetermined, tested, historical drawdown is a good starting place that gives a system plenty of "breathing room".
The 1.5 times the past historical DD admittedly has issues in so far as it has no statistical basis. (Why not 1.35 times, or 2.4 times, etc.), and for that reason Attain uses several other measures to measure 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 R-Mesa data. The simulation, run 5000 times over 1200 months (100 years), randomly shuffles existing data to give probabilities of future drawdowns exceeding certain levels. We plugged in all of the hypothetical backtested results prior to the system's release, and our simulations told us that 99% of the simulation trials saw drawdowns less than 101.21% or ($30,363). This tells us that the current drawdown of ($17,280) is still well below the "line in the sand" generated using a Monte Carlo engine. For more information how Monte Carlo simulations work, see our past newsletter on the subject using this link: http://www.attaincapital.com/alternatives/alt_feb2805.htm#Topic.
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 again quite far from the 1 in 100 year levels, with the estimated future max drawdown (or stop trade point) being approximately $10,000 away.
Finally, we put the six sigma test into effect. To achieve Six Sigma confidence, a process must not produce more than 3.4 defects per million opportunities. Six Sigma standards are common in the production of microchips and high level security software, where the margin for error is razor thin, and in short insures there are six standard deviations between the mean and the nearest specification limit. In trading systems, the mean is your average drawdown, and the specification limit is the max DD you never want to see. The Six Sigma "line in the sand" for R-Mesa 5 is whopping Max DD of -124.62% or ($37,386), which is more than double the current drawdown.
So here we stand, with R-Mesa having had double digit percentage losses in three out of the last five months, and a drawdown that stood at -57% as of last Friday. By all accounts it is a time to worry. But, as shown in the table below, the system has quite a ways to go before it reaches the estimated future drawdown levels we use as potential "lines in the sand" for stopping trading.
While the ample room between the current drawdown level and the stop trade "lines in the sand" is a good sign in so far as it means R-Mesa is operating well within its tested parameters, I am guessing the specter of an R-Mesa DDs as high as 90% of the initial account balance will catch more than a few people off guard. Could it be that the starting point, the developer's recommended initial balance of $30,000 is too low for R-Mesa SP. You can say that again.
With the future Max DDs of R-Mesa averaging over 103% of the $30,000 initial balance, it becomes abundantly clear that a conservative investor should use a value greater than $30,000 per contract for their initial investment in the R-Mesa trading system. Attain Capital recommends starting with at least $50,000 per full size S&P contract for those investors trading the system on its own without any diversification amongst other systems.
The table below shows the current R-Mesa Drawdown as it compares to the pre-release Max DD, and the estimated stop trade/reevaluation levels (lines in the sand) as derived from each of our four methods discussed above, 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 R-Mesa or reevaluate their trading.
What about R-Mesa eRL?
An astute client emailed me today asking whether R-Mesa eRL made more sense moving forward given the ever shrinking daily range in the S&P futures and potentially better trading environment currently available in the Russell 2000 futures.
That is a very good question, I replied. The Russell market is definitely showing much better "internals" than the S&P futures, as far as average range, percent of price it moves in a day, volatility, etc. And we believe that should translate into a better trading environment.
However, many e mini Russell systems have struggled recently as well. R-Mesa eRL is having its worst month since we began trading it, and its worst month ever when considering the backtesting. So, while the Russell market may offer more volatility and better trading opportunities, the flip side of that is the losses could be bigger as well.
One way to consider which system holds the most promise moving forward is to look at the risk vs reward on each system. That is, see how far each is from its stop trade point, and see how much expected profit there is in the next 12 months. We can see in the table above that there is an additional $13.6 K risk in R-Mesa SP, and in doing the same calculations on the eRL, then normalizing the exposure by considering 3 mini Russell per 1 big SP, there is an additional $6,585 risk per 3 e-mini Russell using R-Mesa eRL. On the reward side, the hypothetical average annualized return for R-Mesa SP is just under $40,000 and for R-Mesa eRL its is about $11,000 per 3 e-mini Russell.
So, this exercise tells us that we can risk about $14,000 to make approximately $30,000 over the next 12 months in R-Mesa SP, or we can risk about $6,500 to make approximately $11,000 utilizing R-Mesa eRL. This equates to an expected return over risk ratio of 2.1 for R-Mesa SP and just 1.7 for R-Mesa eRL — pointing to R-Mesa SP as the better risk/reward proposition at this point if you don't mind a higher actual risk amount.
- Jeff Eizenberg
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 |
US stocks had one of their worst weeks of the year last week as another interest rate increase and another major hurricane sent stocks reeling. The Fed raised the Federal overnight rate by another 25 basis points last Tuesday, going in the face of some who thought they may pause in case two major hurricanes took a big toll on the US economy. But the hurricanes have also helped spike energy prices, which may have stoked some inflation fears in the outgoing chairman and kept the Fed at bay, and may keep them raising rates for quite some time. For the week, SP futures finished down -1.76%, NASDAQ futures were down -1.64%, Russell 2000 futures fell -2.34%, and Midcap 400 futures dropped -2.02%.
In energy trading, Hurricane Rita stirred up more worries about production and refining capacity in the US, briefly pushing Crude Oil back above $68 a barrel. But prices came almost all the way back by the close of business on Friday as it became clear the Houston area would be spared, with Crude Oil finishing the week up just +1.34%, Unleaded Gas climbing +1.24%. Natural Gas rallied the highest, gaining +6.81%.
As expected the US Dollar gained some strength on the heels of the Fed’s rate hike. (Higher interest rates make dollar denominated assets like Treasury Bonds and Notes more attractive, thus add demand for dollars) The US Dollar Index climbed +1.33% for the week, while Eurocurrency (-1.56%), the Swiss Franc (-1.83%), and the Japanese Yen (-1.00%) all moved lower against the Dollar.
Metals were rocking due to expected increase in demand over the next 6 months. High Grade Copper led the charge gaining +6.62% last week. In London, the Copper contract gained +2.76%, High Grade Aluminum was up +2.76%, and Nickel was up +15.87%, as traders are expecting a huge increase in demand due to the massive rebuilding projects expected due to the hurricanes. Finally, both Coffee and Cotton made comebacks last week with Coffee gaining +1.44% and Cotton rallying +2.57% higher.
*Day Trading**
Wild swings in energy markets driven by Hurricane Rita proved to be costly for day trading systems, which failed to get into a rhythm last week. While added volatility is generally beneficial to day trading systems, they prefer day to day higher volatility (as in down 150 in the Dow today, up 300 the next day, down 200 the day after that). Higher intraday volatility, with the market (in Dow terms) going from down 100 to up 100, back to even on the day - can cause real havoc to day trading systems.Only a few systems were able to navigate the choppy conditions. Helix ES traded an average of twice per day last week for profits totaling $787.50. BWT Zones eRL was also able to end the week positive, making $475 per contract thanks to some nice reversal trades. Impetus eRL had two trades last week but made just $10 per contract.
Every other system struggled to turn a profit for the week. RC Success ES traded every day of last week but ultimately came up short losing -$355 per contract. Clipper eRL traded three days last week and was unprofitable by -$663.30, while RC Miracles ES traded five times last week for a loss of -$1,012.50 per emini.
Elsewhere, Compass continued to struggle slightly in the month after hitting new equity highs, punching out for the week with a loss of $1,153.20. Another system with a spectacular August but circumspect September has been R-Mesa eRL, which has given back all of its August gains and then some - dropping another -$1,421.60 per contract last week. BWT Zones SP, meanwhile, traded four times last week for losses amounting to -$1,437.50.
And finally, R-Mesa SP set a new Max DD mark (hardly the distinction anyone hopes for) as it traded two days last week, both with reversal trades, for a total loss of -$3,175. See below for a discussion on what the future holds for R-Mesa SP.
**Swing Trading**
In swing trading, the trade of the week was actually no-trade, or hold position. Axiom Index eMD came into last week holding short, and it continued to hold short throughout last week. The position was earning +$1,266.30 coming into today. Elsewhere in the Axiom Index portfolio, the eRL had open and closed trade profits of +$613.80 heading into the day. Not so fortunate were the ES and NQ which lost -$977.50 and -$250 on the week. Axiom Index ES is perilously close to its stop trade point with a drawdown of over 70% this year.
Last week was an active week for Tzar. The system had been holding long coming into the week; however with no upward market trends to speak of Tzar quickly dumped its positions in all 4 markets for a loss. Tzar NQ lost -$1,000, the ES closed out for a loss of -$1,330 and re-entered long later in the week, the eMD lost -$1,975 and is now short, finally the eRL closed out for a loss of -$2388.
The last bit of swing trading came from Eclipse eRL which had 2 solid trades earning a total of $796. Also trading last week were Apollo ES and Athena eRL from Roker Capital Systems; the systems lost -$367.50 and -$580 respectively.
Bond trading had mixed results during the week, with Mesa Bonds and Notes adding $1000 and $265.625 in open trade equity on their long positions despite the rate increase, while the Jaws Narrowneck portfolio lost -$768.75 in closed trades.
Finally Axiom Crude 90 and Axiom Crude 135 both had choppy weeks. Axiom CL 90 had both a long and short entry resulting in -$5,120 in losses while Axiom 135 entered only once late in the week and is currently holding long. (Axiom 90 as traded on the long and short side is traded that way exclusively at Attain).
**Long Term**
Long term traders have seen the good, the bad, and the ugly this year - but not in that order. It has mainly gone the bad, the ugly, and now the good. Positive returns have been difficult to come by, but there are signs that long term trends are re-emerging in the marketplace.
First, as we discussed in the opening , we have seen some impressive rallies in the metals markets. Those familiar with trend following will remember the huge Copper bull market of late 2003 and early 2004 that saw the commodity gain approximately 62%. After a brief pull back earlier this year; it appears that the copper bull market is back with gains of approximately 36% since mid-May. Unfortunately, not many systems have taken advantage of the run up with long positions yet, although Andromeda is holding long and making +$2287.50 per contract.
The Nikkei 225 has also enjoyed a huge bull market run as a potential political shift has investors betting the the Japanese economy will finally start to rebound. Nikkei futures are up an almost unbelievable 19.90% since mid-May and system traders are taking notice. Right now Andromeda continues to pace system investors with gains of +$2550.00 per contract in the Nikkei.
In the grains, Corn has been the best trending market - even if it has been a slow and boring decline. Corn is down approximately -22.38% since mid-July as good growing conditions and light demand have allowed the commodity to fall despite early summer drought warnings. Systems with short positions include SEMA4 Symmetry which is making +$400.00 per contract, Andromeda which is making +$775.00 per contract, Aberration Plus which is making +$25.00 per contract, and Axiom LT which is leading all systems with gains of +$1137.50 per contract. While these gains may seem unimpressive, bear in mind that the risk on many of them was less than $500 per contract, meaning an average investor risking 2% per trade with $100,000 would be long about 4 contracts.
Unfortunately, not all trend followers trades can be winning trades. Some losing trades amongst long term systems include Aberration Plus losing -$915.00 per contract in Palladium after entering long early last week. Palladium had rallied 13.22% over four days but the move hasn’t held up this far as the market turned right back around. The commodity which is know for it’s use in catalytic converters has been home to a few big market trends in years past. But lately the trends have been more difficult to come by as volume has declined throughout the years. Other systems with long positions include Axiom LT which is losing -$375.00 per contract, and Andromeda which is also losing -$915.00 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.