In trading, there is no single right answer. Many different trading concepts can make money on any market or basket of markets. The key to being a successful system trader is to take one of these trading concepts and apply good analysis to the core system to judge its reliability and efficacy. The dilemma in this situation is that even though backtest results may look great, the system cannot always be traded with similar results.
A perfect example of this problem would be an S&P 500 system backtested through a 10-year period from 1997. Assume this system enters the market on a stop order and has an average trade profit of $350 with no deduction for slippage or commission. The system trades an average of 100 times per year for 1,000 trades total during the test.
With these assumptions, it is easy to calculate that the system made about $350,000 during the 10-year period (before transaction costs). However, the results of the backtest would have been sheer fantasy because a $300 slippage and commission charge, at least, needs to be included to reflect volatility on the big S&P 500 contract from 1997 to 2002, especially using stop orders.
Even with the lower recent volatility, $150 per contract needs to be used. In this more accurate case, about $270,000 would be lost in commissions and slippage. In reality, the system only made $80,000 through this 10-year period, or about $80 per trade on the big S&P contract.
This gets to the heart of what’s meant by the efficacy of a trading system. Another example would be purchasing a commercial system that made all of its money trading thin markets like the Mini-Value Line, palladium or rough rice. If the system has sold a few hundred copies, trade entry in these low-volume contracts will be a major problem. If the profits came from liquid markets like crude oil, the 10-year Treasury note, the euro or the Japanese yen, slippage would be far less of an issue.
IT’S MONEY THAT COUNTS
When deciding between developing or purchasing a trading system, a lot depends on some very personal considerations. For example you must:
• Have enough money to trade it correctly
• Have a time frame for success that matches with the goals and abilities of the trading system
• Have a need (or lack thereof) for access to trade profits that the system can keep up with
• Be able to tolerate the reasonable risks taken by the system
Probably the most important consideration is whether you have enough money to trade the system you are considering. Personality conflicts can be dealt with in other ways. Money, however, cannot be pulled out of thin air. Many times, the capital funding issue comes to a head in consideration of the amount of diversification the trading system relies on.
With a $250,000 account, it would be possible to trade a reasonably diverse trend-following basket system, a T-bond system and an E-mini or mini-Nasdaq system with little trouble. Given current volatility and margin levels, in most situations, there would be enough capital to offset the risks of individual trades, such as trading six corn contracts against one bond contract to balance risk.
With this account size you also could consider trading multiple systems. Assuming the systems are not highly correlated, you could smooth your returns considerably. Multiple non-correlated systems can reduce drawdowns greater than trading multiple markets with just one system.
Now, let’s say there’s a $25,000 account. In this case, our trading strategy must be different. There is not enough money to trade a balanced portfolio in all situations. For example, trading corn in a portfolio that is also active in T-bonds might require $6,000 to be tied up in margin at any one time (one bond contract at $3,000 and six corn contracts at about $500 each). That’s a big capital commitment for an account of this size. Sure, it could still trade corn and bonds, but not without compromising either total exposure or risk balance.
The importance of risk balance is often lost on beginning traders, who typically look at simply trading one-lots across the board as spreading risk effectively. Trading system results, whether derived by a commercial developer or an individual, are often risk-balanced to align results with the amount of capital that is available to trade. It is important to remember that the best one-lot system might not be the best on a balanced portfolio.
The bottom line is that for larger traders with more than $250,000 in a trading account, results based on one-lot positions are meaningless. For small traders with less than a $50,000 account, results on a balanced portfolio are meaningless. Larger traders should run test results using a balanced portfolio before deciding to trade a system. If you are a small trader, look at one-lot test results and trade accordingly, accepting the cold hard fact that you may not benefit from balanced risk.
FITTING THE MOLD
Another overlooked factor when trading mechanical systems is the ability to follow the system’s rules and take every trade. This isn’t as easy as it sounds, as many traders have found out.
Suppose you have a $250,000 trading account and have found a good trend-following methodology. The system is robust and has made money every year since 1980. Because your capital base is large enough, you can trade a balanced portfolio.
In this case, your primary worry is whether you can live with the system. A good trend-following basket system is the commodity market equivalent to a buy-and-hold strategy in the stock market. It trades on a diverse portfolio of markets and through time has a high probability of being profitable. If you are investing to attain long-term goals, a trend-following strategy using a basket of markets is a good approach.
However, this type of system makes the bulk of its money off of a few large winning trades. In both testing and reality, about 95% of the profits come from about 5% of the trades.
If you override the system on a just few trades out of 100, it is possible (even likely) that you will turn a long-term winning system into a big loser. For this reason, you need to ask yourself if you can live with winning trades less than 40% of the time. It might be easy to answer in the affirmative but keep in mind that these statistics mean there is a better than 1% chance of seeing five losers in a row every 100 trades. When trading a large basket of markets, you might even see 10 or 20 losing trades in a row. That’s a tough nut to swallow even for the most hardened traders — even if they know from experience that the next trade could be a $40,000 per contract winner in copper or crude that puts them in the black for the year.
If your goals or risk tolerance do not match what the system can provide, then you shouldn’t be trading that system. Manipulating the rules because you are impatient with the results can turn a winning system into a big loser. If you can’t live within the expected parameters, then you need to develop or find another system.
If you discover that one system isn’t right for you, there are other options out there. For example, if you can’t handle the drawdowns of trend following, you could look into countertrend strategies, such as a system based on Commitment of Traders data or intermarket analysis. Systems of this type usually have higher winning percentages, but large blockbuster trades are extremely rare.
For frequent trading, consider a short-term swing trading system or intraday system in stock indexes, bonds or forex. While the volatility of these systems can be extreme, they also offer some level of risk control in that the positions are short-lived and react quicker to changing market conditions. However, with short-term systems, you need to watch the market daily.
Another difficulty in intraday trading is that hesitating two or three minutes to enter a trade can make the difference between a winner and a loser. With a longer-term trading system, the entry is generally not so critical.
Once you have done your soul searching and decided what type of system you can afford to trade, financially and psychologically, it is time to develop your trading program.
DEVELOPING A PLAN
Now, let’s look at a trading account of $50,000. Whatever trading system is developed will have to work with that amount. Simply for the sake of removing some potential personality conflicts from the equation, let’s say a full-service broker will be enlisted to trade the system for the account.
A good strategy will be a long term trend-following system combined with an intermarket bond system. The trend-following system will be the Simple Adaptive Channel Breakout originally published in Futures in the mid 1990s. It has done well through the past 10 years and makes a good core component to a trading program.
Here is the code for the original Adaptive Channel Breakout System:
Dim ChanLen As BarArray
Dim ChanWidth As BarArray
MinMove = GetActiveMinMove()
ChanLen = Min(CInt(CyclePeriod((High + Low) / 2,0) * Mult),100)
Buy(“ChanBuy”,1,Highest(High,ChanLen,0) + MinMove ,Stop,Day)
Sell(“ChanSell”,1,Lowest(Low,ChanLen,0) - MinMove,Stop,Day)
This strategy is tested from 1980 on large baskets of commodities markets. Then, we analyze the results to make our final market selections. We have to be somewhat picky because of the limited amount of trading capital.
The markets are analyzed and selected on a sector basis. Admittedly, much of this process is subjective. For example, metals are compared to metals, so copper is the winner because most of the silver profits occurred in the early 1980s and then again recently after a long dormant period. Copper has had a more consistent pattern of having winning years scattered. We could have picked palladium, but that market has become too illiquid through the past few years to trade.
On the basis of our analysis, the basket of markets in “Selected for duty” (below) was chosen. For the system backtest, $100 was deducted for slippage and commissions and the multiplier input in the system code was set to 1.1 (Mult = 1.1). The combined drawdown of this portfolio is only $29,038. This is the maximum drawdown.
Taking a closer look at the downside, at 90%, the start trade drawdown on the portfolio is less than $15,000 and the margin is less than $10,000 (see “Start me up,” below). Using a $50,000 account, the account is leveraged at less than 20%, which is a reasonable number. This basket of markets could even be traded with a $40,000 account without overtrading.
If we margin ourselves at 20%, the $50,000 account grows to $8.68 million with a compound annual growth rate of 23.49% and a maximum percentage drawdown of 51.13%. The maximum number of contracts traded is 1,450 corn contracts. This is unreasonable to trade because of position size, but it does express how the system actually performs. The Sharpe ratio is 0.71.
Note, however, that the Sharpe ratio is not necessarily higher just because less leverage is used. Our trade plan was optimized from 10% margined to 40% margined and it was found that 20% margined produced the best risk-adjusted returns. This doesn’t mean that this simple adaptive channel system is the best. Other portfolios can be built using other trading systems that perform just as well.
If you use another system, you need to analyze how it performs on a balanced risk basis, as was done here. Profitability on a one-lot basis does not always translate to a balanced portfolio. You can have a system perform well on a one-lot basis but lose money when risk is balanced.
In addition, when reinvesting profits, the issue of profit run-up can be a problem. Position size increases as capital increases. The problem is that after a two-sigma hot streak, you are trading many more contracts and capital will be lost more quickly when losses occur.
These are some of the reasons why reinvestment of profits on a balanced portfolio is a much different animal to one-lot trading.
With some work, it is possible to develop a portfolio that will allow us to use a reasonable account size to trade a trend-following basket system and produce representative performance to that of a larger basket. The Adaptive Channel Breakout methodology could be a starting point or you can choose to build your own trend following system as long as you think about how it performs on a balanced portfolio basis, not just on a one-lot basis.
Trading a trend-following system is good, but if more trading capital was available, it would be advisable to add several countertrend models. Examples would be an intermarket-based bond system and a short term stock index system that holds positions from two to four days. These kinds of systems have low correlation to trend-following systems and will improve the overall results.
One question that needs to be addressed is how to allocate funds to the various systems. For example, we have five markets in our trend-following system. If we added a 10-year
T-note system, would that system receive one-sixth of the trading capital, or would we allocate 25% of the money to the T-note system and 75% to the trend-following system? A lot depends on the decision.
If a portfolio has 20 or 30 markets in it, adding a new system with a few markets will not help diversify across systems that much. Under these circumstances, adding a new system will not help our performance as expected. If a portion of the funds are allocated to each system and divided for each market traded by that system, then a new system will have the effect we expected in improving our risk reward ratio.
Much has been written on trading system development, usually with a similar perspective. This series focused on areas that are often overlooked (data, money management, portfolios) rather than the strategies because as we have seen, these seemingly innocuous elements often make the most difference when it comes to overall profitability. That very well might make these logistical decisions, and not the entry and exit rules, the holy grails of trading system development.
Murray A. Ruggiero Jr. is a consultant in East Haven, Conn. His firm, Ruggiero Associates develops market-timing systems. He is editor-in-chief of Inside Advantage Gold Club (www.iagoldclub.com) and author of Cybernetic Trading Strategies (John Wiley & Sons). E-mail: firstname.lastname@example.org.