The key to living through drawdowns - Stick to your Rules.
June 6, 2005
If you plan on surviving very long in this business of trading system investments, you need to become very familiar with the term drawdown, and even more familiar with how to handle one. With R-Mesa currently hitting a new Max DD and nearly all trend following systems in a drawdown, 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.
Because a drawdown is the difference between a portfolio's highest valuation (in a given period) and its lowest subsequent valuation. This means you are either at new equity highs with your trading system, or are 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.
What will we be writing about R-Mesa, currently in a 46% DD, 6 months from now? 18 months? 5 years? Because R-Mesa is still well within its tested historical norms, I'm betting it will be very similar to the Compass story above. In our opinion, this represents the single best time to get involved trading R-Mesa since the system was released in 2002.
Using the system's actual fills, the system had an average annualized return of just above 40% per year on the developer's recommended initial balance of $30,000. Should R-Mesa hit its annual average this year and return 40%, it will have to do so by first gaining back the 35% it is down. That would be a return of 75% from the current levels. Of course, investors could also see losses through the rest of the year, but with the ability to cap those losses at 1.5 times the old historical max DD, or 44% * 1.5 = 66%, investors are risking just 20% in losses for a potential gain of 75%. I like those odds a lot.
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. If trading systems was easy, everyone would be doing it.
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. With the ability to pay for R-Mesa out of profits and a realistic risk floor of just $6,000 - it is a great time to start trading R-Mesa.
PS - Attain started testing R-Mesa on the emini Russell last year, and impressed with the results and bigger effective ranges of the Russell market; began trading it for client accounts this year. The second graph below shows the R-Mesa eRL performance. The first thing that will jump out at you - it's UP this year (in computer backtesting).
For more information, email invest@attaincapital.com
- 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 |
.gif)
.gif)
Feature | Week In Review | Chart of the Week |
As expected, it was a slow week for stock index futures traders due to the shortened week. The markets were closed on Monday due to Memorial Day and it seemed like most investors took the rest of the week off as well. SP futures traded in a tight 15 point range and finished the week unchanged. NASDAQ and e-mini Russell markets also lacked enthusiasm - ending the week right where they started.
Energy prices continue to play a role in keeping stock investors spooked. Crude oil futures rose +5.23% last week, while unleaded gas futures climbed +5.33%. The rising energy costs helped hold the stock market back despite encouraging M&A news and speculation that the Fed will cease increasing interest rates this quarter.
In bond trading, Friday’s unemployment number was much weaker than expected and US interest rate futures rallied quickly (prices up = rates down). However, the bond market quickly pulled back and by the end of the day was nearly a full basis point lower! Despite Friday’s late sell off, US Bonds remained in positive territory for the week closing +1.29% higher.
The US Dollar continued it’s recent strength as well last week, finishing +1.25% higher. Most of the move came as a result of France and the Netherlands signaling in local elections they would not support ratification of a new European Constitution. Eurocurrency fell -2.89% and the Swiss Franc fell -1.92% on the news. Finally, trading activity was mixed in the grain markets which saw soybeans gain 1.12%, while wheat fell -3.51% and corn dropped -1.36%.
**Day Trading**
You know its summertime in Chicago when the S&Ps are trading in just a fifteen point range for the week. Hopefully the trading activity will pick up in the weeks to come or it could be a long summer for the day traders that earn their keep off of the intraday volatility. Despite the tight trading range, a few systems were able to capitalize on the bullish momentum last week and came out of the week with some modest profits.
BWT Zones SP had its first profitable week in a while, as the new version logged its first full week of activity. The system was very active, trading five times for profits of $2,000 per contract. Performing similarly, BWT Rock N Russell made $1,290 per money management unit. Its best trade was on Wednesday, when the system went long a unit (three contracts), reversed to short (all 3 contracts), then hit two profit targets(exiting one contract at each) before exiting the last out of the three initial contracts on its trailing stop for profits.
The Spectrum systems by Trading Visions thought last week's conditions were setting up for some sort of pullback, and both the S&P and eRL system issued short trades that were profitable as the market indeed had a pullback. Spectrum SP traded on Tuesday, making $500 on the short trade, while Spectrum eRL traded on Friday of last week, making $140 per emini Russell contract.
Other winners included AG Xtreme, which traded three times last week for a gain of $550, and RC Miracles, whose patience in waiting for a sell-off paid off both Thursday and Friday with total profits of $147.50 per contract.
Elsewhere, R-Mesa continues to struggle - hitting a new max DD last week - and gave back another $1,400 on two trades. Day Breaker had similar luck, giving back $662.50 on two trades. Compass traded just once last week, but went long just before the market sold off and lost $1,150 for the week. Clipper traded on Wednesday only as well, but also took a reversal trade making for a total loss of $903.10 per emini contract.
Rounding out the week's losers, RC Success could not stay above water for the week, losing just $77.50 per emini contract, BWT Zones eRL got caught up in some reversal trades and finished the week down $216.70 per contract, and the Electric Day Breaker portfolio took a loss of $900 - the bulk of which was lost in the eRL market. Helix, Cipher and Magnitude all couldn’t turn a profit giving back $537.50, $67.50 and $42.50 respectively.
**Swing Trading**
Last week’s market couldn’t have seen more of an opposite reaction…while most index traders were off enjoying the long weekend the bond market aggressively found its way back to new annual highs on Thursday and Friday in front of the May unemployment report. Stocks closed mixed while 30 year bond prices rose 2.9% before selling off into the weeks close. To clarify, futures bond prices rise when interest and mortgage rates fall - so new annual highs in bond futures are telling us low rates (at least on the long end - 10, 15, 30 year loans) could be here to stay for a while.
We bring up the move higher in bonds because the trade of the week goes to Mesa Bonds, which finally reversed the long position it had been holding since March 23rd. The total trade locked in +$8651.25 per contract after the rollover and closed out trade. The new entry was earning +$606.25 as of Friday’s close. Contrary to the Bonds program, Mesa Notes continues to hold its long position.
Elsewhere, the only two index markets to close in positive territory for the week were the eRL and eMD. Eclipse eRL is currently long the eRL earning +$2,530, and Tzar is long the eMD earning +$930, while Axiom Index is currently long both markets, making +$2,050 and +$1,190 respectively. Axiom is also long the ES, gaining +$1,282.50 and Tzar is long the NQ with open profits of $90. Tzar is also short the eRL and is holding an open trade loss of -$2,110.
**Long Term**
After a tough first four months and mixed May, trend following systems are looking to get fully back on track in June. There have only been a handful of noticeable trends in 2005, but some may be starting to develop. The obvious trend has been energy prices trending higher since briefly hanging out in the mid-40s, but this market has been much too risky for most systems, limiting exposure to the up trend. The second most popular trend has been long bond positions, as bonds continue to defy the odds and rally higher. Unlike energy positions, bond positions have become very popular amongst systems.
Andromeda has been the most aggressive system in the bonds - holding long in the thirty year bonds, ten year notes, five year notes, muni-bonds, and in the Eurobund. All five of these trades are profitable, as the system is making the following amounts in open trade profits as of Friday. +$2575.00 per contract in the bonds, +$1418.74 per contract in the 10 year notes, +148.00 per contract in the five years, +$1387.50 per contract in the muni-bonds, and +$2520.00 per contract in the Eurobund.
Currency positions saw profits last week as well as the US Dollar rallied and foreign currencies sold off. Systems with long US Dollar Index trades include Aberration making +$1710.00 per contract (open trade), Andromeda which is making +$2050.00 per contract (open trade), and Axiom LT which is making +$2930.00 per contract (open trade).
Axiom LT also has been very aggressive with short foreign currency trades. Currently, the system is short in the Swiss Franc for profits of +$4537.50 per contract (open trade) and in the Japanese Yen for profits of +$475.00 per contract (open trade).
Trend followers have also entered short in the stock indices but these trades have been unsuccessful for the most part. Andromeda is holding short for a loss of -$1000.00 per contract in the Nikkei and was stopped out for a small loss of -$30.00 per contract in mid May.
Other positions that were closed last week include a loss of -$632.40 per contract in sugar for Andromeda, a gain of +$1390.00 per Live Cattle contract for Axiom LT, as well as a loss of -$3242.00 per contract in heating oil in Axiom LT. .
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.