Forum Archive Index - March 2003

[Travis Morien <travismorien@yahoo.com>]

--- Phaedrus <Phaedrus@techemail.com> wrote:
>  Let me give you some statistics on a completely
> mechanical short-term trading system that I have
> been running on selected Nasdaq stocks for nearly
> two years :-
>  147 Trades/23 months
>  86 wins
>  61 losses
>  Hit Rate 58.5%
>  72 Longs
>  75 Shorts
>  Average Win 10.47%
>  Average Loss 4.6% 
>  Overall average return/trade 4.2%

What about biggest drawdown and calculated risk of
ruin?

These figures by themselves do not indicate that this
will be a successful trading system over the long
term.  You'd need risk of ruin figures to be well
below 25% for a system to be tradeable consistently.  

Risk of ruin is a probability that can be calculated
statistically based on backtest data for a trading
system.  It calculates the probability of the account
falling below a certain level (below which, the
trader/gambler is "ruined") before it rises to a
profit goal.

RoR depends on the above factors you entered as well
as the order of the wins and losses, how much money
you intend to make, how much money you are prepared to
lose, how big your account is to start with, etc.  The
formula is extremely complicated and RoR can only be
found by iterative computer techniques, except for a
few special (and unrealistic) situations.

You'd probably be interested in the following sites:

http://keplerweb.oeh.uni-linz.ac.at/trading/moneyMan.htm
http://www.futuresmag.com/futuresclassroom/articles/beyondanalysis.html
http://www.futuresmag.com/futuresclassroom/articles/fcr_a_7.html
http://www.futuresmag.com/industry/references/roberts995a.html
http://www.futuresmag.com/industry/downloads/downloads.html

There are various others and I link to quite a few
trader sites from the links section of the aus.invest
FAQ.  (www.travismorien.com/FAQ.htm)

Another book you might be interested in reading is
"Trade Your Way To Financial Freedom" by Van K.Tharp. 
This book is suited for both futures and stock traders
and is generally considered to be one of the best
trading books around.  It only devotes four pages to
trend following though, primarily because the author
believes (as many top traders do) that TA is of only
limited usefulness.  To be fair, the book gives about
the same amount of space to FA.  The key message of
the book is that entry signals are barely relevant
compared to risk management and position sizing.  

"The Turtles" illustrated that point when they gave a
live demonstration and profitably traded a futures
account before an audience, using random buy and sell
points but applying risk management and position
sizing techniques.

> Note: These figures do NOT include brokerage. The
> reason I have left this out is because at a flat
> rate of, say, $20 per round trade, trade size is a
> critical factor in determining profitability. For
> example, with $400 trades, brokerage amounts to 5%,
> and the system loses money. At the other extreme,
> with a trade size of, say, $400,000, brokerage is
> 0.005%, and can be totally ignored.

I'm a little surprised you'd be so bold as to make
this assumption.  Nasdaq stocks were notoriously
illiquid throughout the tech boom and I doubt they've
gotten any more liquid in the last two years now that
the teeming millions of day trader wannabes have quit.
 

Bid/ask spread, which doesn't show up in historic
backtesting unless you've got some pretty amazing
data, is a major expense which could lop off more than
10% per trade for less actively traded Nasdaq stocks
and at least a percentage point on each trade for the
more actively traded ones.

Brokerage is not the important expense, bid/ask spread
is.  See "Do traders Trade too much?" at
http://faculty.haas.berkeley.edu/odean/

Note that Odean is generally talking about NYSE
stocks, if we transpose his comments to Nasdaq you
could multiply them by five.

Odean's findings are that the performance of traders
got substantially worse when they changed from phone
discount brokers to Internet discount brokers. 
Brokerage went down, but trading went up.  The factor
that was killing them most of all was the bid/ask
spread.

>  I developed and tested this system by exhaustively
> backtesting over many stocks and many years. Actual
> results have not been quite as good as the
> backtests, but are nevertheless acceptable. The

I'm not too surprised that the system performed better
in testing than real life, considering the liquidity
expenses.  When you were testing this system, what
information did you have about stock liquidity for the
stocks you were looking at?

Allowing for liquidity costs, is the system giving
better or worse returns in real life than it did in
the testing period?

> worst aspect of this system is the fact that losses
> seem to come in runs. At one point I had 8
> consecutive losing trades. At another, 11 out of 13
> trades were losses. It takes a lot of faith to
> persist with any system giving such results. The
> faith comes from backtesting - I knew that drawdowns
> of this type occur with this system, and I knew that
> overall, it was robust and profitable.

You'd want to know about the average length of these
losing series and you can adopt a variety of trade
sizing strategies.  For example so-called "improper
money management" would involve increasing or
decreasing your trade size depending on your progress.
 There are various things you can do, the so called
"winning series" (a form of pyramiding, linearly
increase your trade size with each winning trade),
"losing series" (after a certain number of losing
trades you start to increase your trade linearly with
each losing trade), "underwater shutdown" (set trade
size to zero, but keep trading notionally until the
system starts giving profitably signals again, when
equity goes below a certain limit.  The idea behind
this is to get you out of the market when you are just
having a bad day).  

"Proper money management" techniques (these are trader
terms, I'm not being judgemental) don't rely on runs
of good or bad luck but instead calculate a fixed
fraction of the portfolio to be traded on each trade,
using methods like Optimal f, Secure f, Fixed Ratio
and Fixed Fraction etc.  You'll find all those terms
defined at the various web sites I've referred to
above.

Travis
www.travismorien.com

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