The Paradox: Losing money on a Winning system
October 31, 2005
New all time Equity highs! $11,670 in profits this month ! $83,640 in profits per contract since live trading began in March of 2000! The $19,470 drawdown last year doesn't look so bad now, and Compass is on top of the trading system world for now.
But it isn't all accolades and good times for Compass investors. The hidden side of Compass's huge run up to new equity highs this month is the long list of former Compass clients who for one reason or another stopped trading the system.
We pulled out the list of former Compass clients last week and read through the names as if reading the names of fallen comrades. Bob from Texas, David in new York, Christine in Florida, Shirley in California, Hans from Denmark - if only they could have held on a little longer....
It seems as if it never fails to happen. Is it bad luck, or some form of Murphy's law (what can go wrong will go wrong)? Its hard to tell, maybe some investors are just destined to lose money, but there are always a few tough luck stories of investors who have lost money trading a profitable system.
How can that be, you ask? Well, for one thing, the investment probably didn't look like a profitable one at the time the clients stopped. Many clients dropped Compass last year as the system struggled to its first losing year on record and suffered through a lengthy drawdown that reached -$19,470 at its low point.
But the system always maintained a positive average annual return, and more importantly never eclipsed the statistical line in the sand Attain sets for each system we trade. If each of those former clients had followed their initial investment plan and vowed not to stop trading the system until it breached its "stop trade point", many more of them would be enjoying the run up in profits rather than watching from the sidelines.
Hindsight is 20/20, as the old saying goes, but learning from those investors who lost money trading a winning system should help future investors avoid the same mistake
What causes us to behave in such ways? How can we let emotions into a system trading realm which is ruled by mechanical, non-emotional decisions. The disconnect occurs at the portfolio, or asset allocation, level. While the actual trade by trade decisions of a system are mechanical and consistent, the decision to start or stop a system is still predominantly an emotional one.
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.
Attain has also found the decision to stop trading a system becomes more emotional and ill-timed the more an investor "watches" their investment. This makes sense given that most systems make money on only about 35% to 50% of their trades, meaning a trading system investor watching every trade will be disappointed in what she sees the majority of the time.
The following discussion, including the statistics and numbers within, can be directly attributed to Nassim Taleb, from his excellent book, Fooled by Randomness, Texere, LLC Publishing, 2001.
Many investors believe if they had an investment which had a 93% probability of making money each year, they would have found the holy grail. Such an investment would be ideal, and put simply would mean that roughly nine out of every ten years would be profitable.
Consider the troubling idea that a grand majority of investors involved in such investments ultimately lose money. How can that be? - you ask, when there is a 93% probability of success.
Too Close to the Action
Many investors lose money trading systems for the simple fact that they get too close to the action. The great majority of what goes on in a normal trading system account is just noise - with small losers, winners, break even trades, and more going on a daily basis.
Investors who zero in on this noise, instead of the end result can fall into the very dangerous trap of judging their investment too soon. It is the investing equivalent of 'judging a book by its cover', and can lead to an investor stopping a profitable trading systems.
Consider the investor who enjoys a "15% return per year, with 10% volatility per annum. This translates into a 93% probability of making money in any given year. But seen on narrow time scale, this translates into a mere 50.02% probability of making money over any given second."
The investor who checks this account on a second by second basis has no chance of long term success. The investor will be an emotional wreck: "…each day he will have 241 [profitable] minutes against 239 [non-profitable] ones." They will jump off systems at the wrong time, and jump on new systems at equally poor times. They are investing based on the noise, not the facts.
As many investors will attest to, a non-profitable minute (or day) causes much more harm, than a profitable one causes benefit, thus even though the minutes are almost evenly spaced, the emotional drain of all those non-profitable minutes will start to weigh on the decision maker. The result will be an emotional decision to stop trading a system which has a high probability of long term success.
The investor who looks at her statements on a daily basis will have 167 days in which they need to mentally handle losses, versus 197 enjoyable statements. Compare this with the investor who only checks her statements on a monthly basis, being challenged by losses only 4 times out of a year. Now consider this same account, viewed on a yearly basis, would have positive returns on the statement 19 out of 20 years, or 93% of the time. This investor would be crazy to stop the investment, for fear of not enjoying the next 19 profitable years, but the investor who quits after 2 out of 3 losing months deems herself wise.
It goes against human intuition to believe that something which can be witnessed losing money 50% of the time on a daily basis will make money 93% of the time on a yearly basis. It just doesn't seem to make sense, and the reason it doesn't is it's caused by randomness. There is simply a lot of random noise present when viewing performance on a daily basis, and it is extremely difficult to filter out this noise.
The following table shows the probability of viewing a positive return in an account which makes a 15% annual return with 10% volatility at different time intervals.
- 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.
Feature | Week In Review | Chart of the Week |
Feature | Week In Review | Chart of the Week |
The month of October has historically been known for its large stock market crashes, and while the market did not exactly crash this October, it did become much more volatile. Market volatility as measured by the CBOE VIX index increased over 28% this past month. Factors including earnings reports from most of the SP 500, 2 major hurricanes, and the nomination of a new Federal Reserve Bank Chairmen kept traders on edge throughout the month.
The volatility increase was a much needed wake up call for the US Stock market which had been seemingly stuck in place during September, and was a much needed boost for day trading and swing trading systems that struggled last month. Overall, the market didn't fare well, with SP futures dropping -2.51%, NASDAQ futures down, -2.48%, and Russell 2000 futures the hardest hit of all down -4.45%.
Signs of relief from higher energy prices appear to on the way as all 4 major energy markets moved lower in October. The benchmark NYMEX crude oil contract fell -9.54% as production began to pick up again in Gulf Coast refineries. Meanwhile, Unleaded Gas futures fell -25.21%, and hopefully gas prices will be under $3.00 a gallon for some time. Finally, winter is also looking more bearable as Natural Gas futures fell -17.87% and Heating Oil futures dropped -15.88%.
While the stock market had its eye on corporate earnings, bond and currency traders had their eyes on Washington in anticipation of a replacement being named for Alan Greenspan. Specifically, traders were looking for signs of whether the strong policy against inflation would continue in Washington signaling more rate increases. When well known inflation fighter Ben Bernanke was nominated to the post US Bonds reacted as expected moving lower and finishing the month down -2.16%, while US 10 years moved -1.35% lower.
Surprisingly, the foreign currency markets barely budged with Eurocurrency, the Swiss Franc, and Dollar Index all remaining virtually unchanged for the month. Japanese Yen futures continued to weaken however, falling -2.63%, and lower crude oil prices helped push the Canadian Dollar down -1.80%.
Other markets that moved lower in October include Wheat which fell -9.00%, Corn which was down -4.50%, Lean Hogs dropped -2.60%, and Cotton moved -2.18% lower. Markets moving to the upside include High Grade Copper which gained +5.35%, Feeder Cattle was up +1.27%, Live Cattle rose +1.05%, and Sugar climbed +1.00%.
*Day Trading**
October was a system trader’s dream-increased volatility, huge trading ranges, and a lot of follow-through in the equity futures- which all helped several systems have their best month of the year.
Patience is a virtue, and Compass traders were rewarded for sticking through last year's hard times with a gain of +$11,859.35 in the month of October. The Compass system finished the month at new all time equity highs after posting its second largest monthly gain in the five years of actual trading. R-Mesa SP was more active than usual, trading sixteen times for total profits of +$2,489.40 for the month.
Two systems relatively new to Attain - Bounce eRL and Bounce eMD - were both profitable on their “long only†strategies in October, making +$1,350 and $900 respectively.Elsewhere, Electric Daybreaker II was profitable in two out of three markets currently traded, making +$830 in the NQ, +$170 in the eRL nut losing -$50 in the ES, and Nautilus ES ramped up its trading in October and made +$267.50 per emini contract.
But it wasn’t smooth sailing for all the day trading systems. Impetus eRL traded twelve times in October for a loss of -$359.20 per contract, RC Miracles and RC Success were down for the month as well, losing -$795 and -$1,812.05 per contract respectively, while Helix ES struggled to monthly losses of -$3,032.50.
Clipper eRL, meanwhile, did not perform like that of sister system Compass and lost -$2,033 per contract for the month on its way to eclipsing Attain's recommended "stop trade point". Some investors are hanging on hoping for a Compass like rise from the drawdown lows, but the risk on the Clipper system has definitely increased.
R-Mesa eRL also failed to capitalize on the increased volatility in October, losing -$4,442.90; while Daybreaker SP traded nine times during the month for a total loss of -$5,430.97.
**Swing Trading**
Noting that the volatility, as tracked by the CBOE, jumped a remarkable 22.98% in the S&P from the end of September through today it comes to no surprise that many swing trading systems were busy jockeying for position throughout October.
The stock index swing trade of the month and quite possibly the year goes to Axiom eMD which earned a remarkable 28.24% on the month or +$4,237.10 in open and closed trade profits (based on a $15,000 recommended account size per contract). The eMD continues to roll over the competition and has earned over 75% in the last full 1 year period. For this system it is more than volatility that has helped it in its climb to the top; the eMD market alone has earned +15.58% over the same 1 year period, suggesting that there have been some impressive trends for the system to capitalize on.
Not to be outdone, the newly released Delphi eMD also was quick to capitalize on the swings. The system earned +$2,447.50 in open and closed trade profits. Other index trading for the month included impressive gains of +$1,070 by Bounce eRL Swing (long only system) and +$330 for Bounce eMD Swing.
There were mainly gains across the board elsewhere, with Delphi eRL earning +$800, Eclipse eRL gaining +$679.10, Axiom NQ making +$660, Tzar ES earning +$535, and Axiom ES gaining +$522.50 when considering both open and closed trades.
On the losing side of the ledger — Tzar NQ lost -$330, Axiom eRL finished down -$405.20, Athena eRL lost -$1,160, Tzar eRL gave back -$1,690, and finally Tzar eMD was the hardest hit losing -$7,440.
Index trading was not the only exciting market, as 30 year bonds finally stuck to a down trend long enough for the Jaws Narrowneck Bond portfolio to capitalize on a few big down days. The combined 3 system portfolio raked in +$2,175 on 9 trades. Unfortunately for Mesa Bonds and Notes their counter trend logic did not prove as successful; both systems are long the bonds. Mesa Bonds closed out an open trade and then re-entered long the following day.
Finally, the 2 Axiom Crude short term swing systems hung onto their short side biases heading into the last day of the month where Crude finished down -$1.18 for the day. On the month the returns were not quite as favorable as today – In open and closed trade profits - Axiom CL 90 gave back -$450 on 3 trades while Axiom CL 135 gave back -$1,990.
**Long Term**
Inflation was the hot topic amongst bond traders in October as investors want to know if inflation is increasing, and if so, will the Fed continue to raise rates? Well, most traders and consumers now seemed resigned to the fact that the Federal Reserve will indeed continue to raise interest rates for the foreseeable future. What does this mean for trend following system traders? Expect to see an influx of new short positions in your account because as the Fed raises rates bond yields move higher which causes bond prices to move lower.
Systems with short positions include Axiom LT which is short in the US 10 year for profits of +$2059.37 per contract, and in the Simex Japanese Bond for profits of +$1787.88 per contract. Aberration Plus is short in Eurodollars for profits of +$362.50 per contract, short in Aussie 10 years for profits of +$657.79, and is also short in the US 5 year note and US 2 year note for small profits of +$28.13 per contract. Andromeda is also short in a few markets including 30 year bonds for profits of +$731.25 per contract, 5 year notes for profits of +$371.88 per contract, Muni Bonds for profits of +$543.75 per contract, Eurodollars for profits of +$375.00 per contract, and in the Eurobund for profits of +$470.00 per contract. Finally, SEMA4 Symmetry entered short in the 5 year notes on Friday and is losing -$159.37 per contract.
Elsewhere, the metals markets continue to look profitable for those holding long positions. Aberration Plus is one of many systems with a long position in Palladium and the system is making +$2190.00 per contract on the trade. Andromeda is also long in Palladium for gains of +$2190.00 per contract, and the system is holding long in platinum for profits of +$540.00 per contract, gold for profits of +$2160.00 per contract, and in high grade copper for profits of +$5325.00 per contract, and SEMA4 Symmetry is long in gold for profits of +$1470.00 per contract. Axiom LT was stopped out of two LME Aluminum trades for a total loss of -$1812.25 per contract.
Finally, after rising higher after Hurricane Katrina, cotton prices have begun to resume their downward trend. Unfortunately there were a few systems that entered long during October on the heels of all the hurricane activity. Systems with long positions include Axiom LT for a loss of -$1045.00 per contract and Aberration Plus for a loss of -$2240.00 per contract, while Andromeda was stopped out for a loss of -$1700.00 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.