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Should you Start a system at New Equity Highs?

November 28, 2005

 

With the Compass SP and Axiom eMD systems hitting new equity highs in October and again here in November, we have fielded a lot of calls and answered a lot of emails concerning getting started on those systems. Most of these investors are confident in the systems and sure they want to trade them - but are wondering about the timing of getting started.

One thing many investors want to know is whether it's a good idea to get in at new equity highs, or whether they should wait for a small pull back before getting started. In a similar light - many existing customers may want to know whether they should "pull some money off the table" after the recent run ups. The common wisdom seems to hold that systems at new equity highs have made a lot of money to get there, and that there is just as much of a chance of the system entering a new drawdown from that point as there is in the system continuing onwards an upwards.

The first thing we need to establish is what exactly is a "New Equity High". Simply put, a new equity high is similar to your IBM or Starbucks stock hitting a new all time high. Trading systems don't have stock prices, of course, but the percentage gains or losses a system incurs add up to build or subtract from the starting equity. If we plot the daily or monthly total equity, we come up with a graph hopefully showing a nice upwardly sloping line. We call this line the equity curve.

The actual Compass S&P equity curve is below:

In the case of the Compass S&P day trading system, an investor starting the system in March of 2000 with a single S&P contract, and trading it through today would now have just under $120,000. Those 5 1/2 years were not made up of month after month of profitability, however. As you can see on the graph above, there were several spells during which the investment was heading lower.

For example, our model investor trading the system since inception would have seen her account value at $62,130 at the end of February 2001. She would not see her account at a level higher than that, however, for eight whole months, as the system lost money in some months, then alternated losing and winning months as it started building back towards the old "high mark" in the account. In October of 2001, her account would have stood at $62,610 -representing a "New Equity High".

The "New Equity Highs" for the Compass system on an end of month basis are shown on the graph above as Orange diamonds. There have been 19 new equity highs for the Compass system since its release in 2000. That's about 4 new equity highs per year.

We love to see new equity highs because it validates a system. No matter when you started a system, a new equity high for that system means your account is at a new personal high level as well. This is of the utmost importance, obviously, because the name of the game is making money, and if a system is not eventually hitting a new equity high, your investment in that system is not growing.

Another way to view New Equity Highs is as the end of a drawdown. While we often think of drawdowns as the amount a system "falls" before it starts to make money again, that is actually the maximum magnitude of a drawdown phase. A drawdown is technically both the magnitude and duration of time between equity peaks. So a new equity peak marks the end of the drawdown.

We have written in this space about a "value investing" strategy in which investors purposefully get involved with systems in drawdowns - and we still hold that is a valid strategy because the amount of risk - as measured by the difference between the current equity level and the stop trade level - is by definition - smaller when in drawdown.

But the numbers look a little too good when looking back at how investors would have done investing at the low point of past drawdowns. For example, Compass was down 17% at one point this year - but is now up 65%. An investor getting in on the very next trade after hitting the low point of the year would have made the 17% to get back to even, PLUS the 65% the system has gained since.

But how realistic is it that you could pick the exact bottom of the system's drawdown. If a signal went off when a system had hit the exact bottom point of its drawdown - trading systems would be similar to printing money, but the truth is, you never know when the bottom of the drawdown is, meaning there is always the possibility of more downside. The power of investing at new equity highs is you know exactly when the drawdown has ended.

New Equity High Strategies:

Because the new equity high marks the end of the drawdown and is a measurable event, we can test different strategies for investing when new equity highs are made. We ran several tests on how to best utilize the new equity highs today.

Our first test was to see what the performance would have been had an investor not traded the system until it hits a new equity high, then only trade it for various amounts of time - 10 days, 20 days, 50 days, etc. The results of which were inconclusive and didn't add much to performance at all.

Next, we looked at only trading the system if there had been a certain number of equity highs in the past 10 days. We tested everything from at least 1 equity high up through 10 equity highs in 10 and 20 days. The results on this strategy were somewhat promising, with drawdowns coming down - as this would keep an investor out of a lengthy drawdown period in which there are no new equity highs. But the total and average annual returns also came down, making the return to risk ratios not as promising as trading the system in the normal manner.

*Hypothetical Model Account

Finally - we looked at only starting the Compass system when it hits new equity highs, then stopping the system when certain drawdown thresholds are hit - 15%, 20%, 30%, etc.- then restarting the system once another new equity high is hit. These results were again not as good as the original - with drawdowns again coming down slightly, but returns also coming down to lower the return over risk ratios.

*Hypothetical Model Account

With both of these Equity Curve trading "strategies" not doing much for improving returns while reducing risk, we took a step back and revisited the question we started with - does it make sense to start trading a system (and Compass in particular) at new equity highs.

The following table lists each of the 19 New Equity Highs made by the Compass system over the past 5 1/2 years, then shows the 3, 6, 12, 24, and 36 month returns had an investor started trading the system on the very next trade following the system hitting new equity highs.

The results were encouraging, with the period returns for each time frame positive and no discernible difference showing between starting at equity highs and the monthly averages of the systems. We listed the actual system averages as traded in the normal manner for comparison in the last line of the table.

While only testing one system, Compass, these results show that concerns about starting a system at new equity highs are unfounded. While you may not get the "bargain" you would if starting a system at or near max DD, the results you get moving forward will be in line with the system's averages and in line with expectations. In the case of Compass with average annual returns of close to 50% - you can't ask for much more.

- Jeff Malec