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Improving performance with a filter to avoid losing streaks.

February 27, 2006

What if there was a way to increase a system's net profit by about 5%, while decreasing the Max DD by about 40% ? Would you be interested? I sure would.

This is every system traders dream - filter out the drawdown phase while getting in at the bottom, enjoying all of a system's run up. But the reason it is just a dream centers around the extreme difficulty in coming up with an indicator which filters out a system's losers while hanging on to a big portion of its winners. Cutting the drawdown is usually pretty easy, but the savings in drawdown is more often than not at the expense of profits.

Attain has been testing hundreds of ideas and filters over the past few months, in order to improve upon trading system performance. We are firm believers in sticking with a system - but with several prominent systems such as R-Mesa suffering new Max DDs over the past six months - several clients have called upon us to help them improve their performance.

Most of our early work on overlaying some system filters was based on market characteristics - looking at market volume, breadth, volatility, etc. While there have been some promising developments in this regard - most of these market based filters did not hold up across the universe of systems we track and have data on, and that qualifier was paramount to our research. After all - if we're trying to create a filter to minimize curve fitting, we don't want to curve fit the filter.

So we moved into the very tricky area of using the equity curve itself as a filter. Some of our ideas for trading an equity curve revolved around using stochastics or relative strength indicators to pick tops and bottoms in the equity curve, but we found the most success using moving average cross overs of the equity curve to signal whether to be "ON" or "OFF" a system.

Much in the way you might trade a stock around its 200 day moving average, the MA cross over filter we tested would have an investor "ON" a trading a system when the 10 day moving average of system equity is over the 200 day average, for example; and "OFF" the system when the 50 day average has dipped below the 200 day average. This is basic technical analysis 101, but its use on the actual equity curve of the system has been limited at best.

We tried several different moving average lengths for the fast and slow curves, and came up with several combinations that tested "ok" on the hypothetical results of 81 trading systems currently in our testing database. What's "ok"? The Net Profit divided by Max DD risk adjusted return ratio rose by an average of 42%. What's that mean in layman's terms - the testing showed the systems making nearly 50% more money for every dollar of drawdown when applying the filter. The Max Drawdown fell by an average of 16%, and the net profit fell by an average of -130%; with 41% of systems showing improvement using the filter. Here are the top 10 systems in the test using only pre-release hypothetical data:

This table shows the percentage improvement in Drawdown, Ending Equity, and the Net Equity/Max DD ratio for the listed systems after applying an equity curve filter. These numbers are the results of testing only, and do not represent trading in actual accounts. Please see the disclaimer at the bottom of the page.

But the testing really hit home when we applied the filter to only those systems we have actual trading results for. Using the filter across 48 different trading systems we have actual results for, our filter improved the risk adjusted returns for 83% of them (39 out of 48); with the Net Profit/Max DD ratio rising an average of 401%!! That's 400% more return for every dollar of drawdown than you would get when trading the system normally. The rest of the numbers line up with the dream of reducing drawdown while increasing return, with the Max DD falling an average of 38%, and the Net Profit actually rising an average of 5.63%. Wow! Here are the top 10 systems in the test using only actual fill data:

What is going on here? Why the difference in the testing between the hypothetical results and the actual results? That stumped us for a while, as both sets included the same commissions charge and slippage. But then it hit us.

If the hypothetical, pre-release testing of many trading systems has been developed on the known market environment up to that time, it is more than possible that the system will encounter a different trading environment in the future. And if you're a cynic and believe the pre-release testing contains a certain degree of curve fitting (intentionally or accidentally - it doesn't matter), then you're thinking that there will be a lot of poor trading environments for trading systems in the future.

So while the pre-release testing had little or no "bad" environments, the future performance of the system will have several such environments, making it not only more important to try and filter out those bad times - but easier to identify them, as there will be more of them (and they will last longer). In short - there's not a lot of bad (or long) losing streaks in pre-release testing, as that would not wet an investor's appetite in the first place. But there is the very real chance that there will be some bad losing streaks in the future. Whether there are or not, it seems to make sense to have some hedge against them happening.

The moving average filter signals a system is entering a poor environment by seeing the current performance of the system not match up with the long term performance. That signal means the current environment may be a poor one for the system, and lets the investor sit on the sideline until that time is over (as signaled by the short term system performance moving back to or above its historical norms).

The 2nd table above shows 10 of the systems which had the biggest Net Equity/Max DD ratio increase after applying the filter. It should come to no surprise that several of the systems on the list have lost money in actual trading (BWT Rock/N Russell, R-Mesa eRL, Cipher, etc.) - as those systems have encountered losing streaks which needed to be filtered out. It's common sense, really; those systems needed the help a filter could provide. But a filter than can turn a losing system into a winner has a lot of appeal, obviously. After all, a system's equity curve moves up and down just like any other piece of market data, and you should theoretically be able to trade those moves profitably.

So is it time to dust off some old systems like Blue Wave's Rock'N Russell, or I-Master? It could be. The results of the filter are encouraging, and it seems to be quite logical. Systems don't break, remember, they just become more risky (have more or longer losing streaks) as they cycle in and out of "phase". So the trick is keeping some exposure to the system in an attempt to profit when the system is "in phase", while using a filter to keep you on the sideline while the system is "out of phase".

Want to trade using this filter, or have a system you want to see it tested on? Just pick up the phone and call us at (800) 311.1145. We're not giving out the exact parameters of this filter due to our excitement of the possibilities it may bring, but can of course implement it for Attain clients.

- 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 : Top Performing Systems - February

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The Week in Review: US stock rally helps swing traders!

***Overview***

As the old saying goes, no news is good news, and the US Stock market followed this mantra last week by slowly climbing higher despite a lack of news and economic reports. That will change this week however as a slew of economic reports are due to be released including the popular US Unemployment report on Friday at 7:30 a.m.

Last week SP futures closed +0.30% higher as the US economy appears to be chugging along rather nicely. NASDAQ futures were up nearly the same climbing +0.35%, while the Smallcaps led the way with Russell 2000 futures gaining +0.97% and SP Midcap 400 futures climbing +1.11%.

Elsewhere Crude Oil futures and Heating Oil futures rallied higher after an apparent failed attack on the largest oil refinery in Saudi Arabia. Crude Oil futures rallied +2.64% higher on the news while Heating Oil was up +3.53%. Unleaded Gas traders did not seem to be worried with Unleaded Gas futures falling -0.60% for the week while Natural Gas futures fell -0.84%.

The metals markets bounced back last week as Platinum futures rose +2.47%, Gold climbed +1.19%, Copper was up +0.98%, while Palladium remained unchanged.

Grains also continue to rally especially in the wheat markets as Kansas City Wheat gained +1.66% and Minneapolis Wheat was up +1.01%. CBOT ended the week unchanged as the Chicago grains did not have as much strength as their Midwest counterparts. Other Chicago grains on the move last week include Soybeans which fell -3.95% and Corn which climbed +0.63.

The soft (tropical) markets were also up and down with Sugar climbing +1.19%, Coffee was up +1.12%, while Cotton Fell -1.27%.

Finally the meat markets moved lower with Lean Hogs falling -2.77% and Live Cattle falling -0.80%.

***Day Trading***

Stock index futures were in the doldrums last week following the U.S. Holiday on Monday in observance of Presidentâ€™s Day. The market showed signs of life a few times throughout the week but most of the buying was short-lived. It follows that day trading activity was slow again last week, leaving just two days for systems to tack on some profits before the final tallies for February.

At the risk of sounding like a broken record, RC Success continues to add to its bottom line and added +$955.20 in the eRL, +$270 in the eMD and -$15 in the ES. RC Miracles was equally impressive, with profits of +$695 in the eMD and +$440 in the eRL.

Rounding out the week's activity, R-Mesa SP had a small winning trade on Monday good for profits of +$100 in what is hopefully the start of the long climb back to new equity highs. Tanker CL had two trades that lost -$350 total for the week. Compass SP continues to tread water and lost -$655.23 for the week on a single long trade that quickly went sour; while Compass eRL had one long trade as well but made +$41.10 per contract. While the two systems do share the same exact logic, the differences in the SP and eRL markets makes trading both in tandem a viable option.

Finally, SPMD lost -$1000 on two trades. On Monday, the system went short and reversed long only to watch the market turn right around and head lower towards the end of the day.

***Swing Trading***

Axiom eMD slowly added to its bottom line to earn last weekâ€™s trade of the week. After going flat early in the week with a small gain of $80, the system reentered long the market and ended the week up +$770 including open trade equity. Axiom eMD was last yearâ€™s top performing swing trading system earning +39.4% based on 15k invested after commissions and system lease fees. The system has struggled so far this year as it is down -9%; however as investors are currently seeing, when the markets trend the system does very well (current open trade equity is +$1060).

In other trading Tzar NQ reversed short locking in gains of +$260; however lost -$50 on the week as the NQ continued higher. Tzar also reversed short the eMD for a gain of +$876; however lost -$598 on the week. Tzar in now short all four US indices at a small loss, but long the Dax and Hang Seng market holding on to significant gains (+4,700 Euro in the Dax and +$2,307 in the Hang Seng).

Seasonal ST ES and eRL also traded last week; unfortunately the short seasonal play did not work out this time around as the system lost -$217.50 in the ES and -$670 in the eRL. Axiom NQ was the final index trade of the week â€“ the system lost -$410 on the week and is now long.

The only other index system not mentioned so far is Delphi which was holding long coming into the day; however with todayâ€™s up move was successful in hitting profit targets in both the eMD and eRL. Delphi eMD locked in +$1,441.70 while Delphi eRL added +$2,080 on trades it had been holding since 2/15 and 2/14 â€“ great trades!

In the bond and crude markets results were mixed â€“ Mesa Notes added the only positive returns of +4246.875 on a short position. Mesa Bonds gave back -$448.4375, Jaws Narrowneck lost -$550 on the week but was short coming into the day (bonds were down 12), and finally Axiom CL 90 and 135 both gave back -$1,620 in open trade equity on short positions they have been holding since the beginning of the month.

***Long Term***

It is no secret that volatility in the US Bond markets has been dropping at an alarming rate over the last 2 years, falling an approximate 40.00% over the last 20 months. Of course it is easy to speculate why volatility has fallen off with everything from inverted yield curves, to deliberate 0.25 point interest rate hikes, and even the retirement of Fed Chairman Allen Greenspan being considered.

However, much like the US Stock market which has been slowly crawling higher the US Bond market has been slowly moving downward and trend following systems are taking advantage with short positions. The shorter term bonds including two year notes, five year notes, and Eurodollars are more popular for systems with short positions, which makes sense considering the inverted yield curve and the rise of short term interest rates. But trend followers are also entering short in the longer term ten year note and thirty year bond markets as well.

SEMA4 Symmetry was one of the first systems to enter short in the bond markets, which is ironic in itself considering it is traded on a longer time frame (weekly bars) than most trend following systems (daily bars). Regardless the system went short in the five year notes in late November and is now has open trade profits of +$770.31 per contract.

Other systems with short positions in short term debt futures include Trend Simplicity which is short in the 5 years for open trade profits of +$7625.50 per contract. Andromeda is short in the 5 years for open trade profits of +$356.25 per contract and Eurodollars for open trade profits of +$275.00 per contract. Aberration Plus is short in the 2 years for open trade profits of +$356.25 per contract, while also holding short in the 5 years for an open trade loss of -$18.75 per contract.

Short positions in longer term bond futures like the 10 year note and 30 year bond are also becoming more popular amongst trend following systems. One system that is taking advantage of the trend is Axiom LT which is short in the 10 years for open trade profits of +$559.38. Other systems with short positions include Brix which is short in 30 year bond futures for open trade profits of +$918.75 per contract and 10 year note futures for open trade profits of +$637.50 per contract. Andromeda is short in the 10 years for open trade profits of +$59.38 per contract. Finally, in addition to its short 5 year note position Trend Simplicity is short in the 10 years for open trade profits of +$762.00 per contract and in the 30 year bonds for open trade losses of -$456.25 per contract.

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